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Cumulative Prospect Theory and Mean Variance Analysis: A Rigorous Comparison

Author

Listed:
  • Thorsten HENS

    (University of Zurich and Norwegian School of Economics and Business Administration and Swiss Finance Institute)

  • János MAYER

    (University of Zurich)

Abstract

We compare asset allocations that are derived for cumulative prospect theory (CPT) based on two different methods: maximizing CPT along the mean {variance efficient frontier and maximizing CPT without this restriction. We find that with normally distributed returns, the difference between these two approaches is negligible. However, if standard asset allocation data for pension funds are considered, the difference is considerable. Moreover, for certain types of derivatives, such as call options, the restriction of asset allocations to the mean-variance efficient frontier produces sizable losses in various respects, including decreases in expected returns and expected utility.

Suggested Citation

  • Thorsten HENS & János MAYER, 2014. "Cumulative Prospect Theory and Mean Variance Analysis: A Rigorous Comparison," Swiss Finance Institute Research Paper Series 14-23, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp1423
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    File URL: http://ssrn.com/abstract=2417191
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    Cited by:

    1. Fulga, Cristinca, 2016. "Portfolio optimization under loss aversion," European Journal of Operational Research, Elsevier, vol. 251(1), pages 310-322.
    2. Thorsten Hens & János Mayer, 2018. "Decision Theory Matters for Financial Advice," Computational Economics, Springer;Society for Computational Economics, vol. 52(1), pages 195-226, June.
    3. Wencheng Yu & Shaobo Liu & Lili Ding, 2021. "Efficiency Evaluation and Selection Strategies for Green Portfolios under Different Risk Appetites," Sustainability, MDPI, vol. 13(4), pages 1-15, February.
    4. Fortin, Ines & Hlouskova, Jaroslava, 2024. "Prospect theory and asset allocation," The Quarterly Review of Economics and Finance, Elsevier, vol. 94(C), pages 214-240.
    5. Fulga, Cristinca, 2016. "Portfolio optimization with disutility-based risk measure," European Journal of Operational Research, Elsevier, vol. 251(2), pages 541-553.
    6. Giorgio Consigli & Asmerilda Hitaj & Elisa Mastrogiacomo, 2019. "Portfolio choice under cumulative prospect theory: sensitivity analysis and an empirical study," Computational Management Science, Springer, vol. 16(1), pages 129-154, February.

    More about this item

    Keywords

    Cumulative Prospect Theory; Mean Variance Analysis;

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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