Prospect theory and mean-variance analysis

Haim Levy*, Moshe Levy

*Corresponding author for this work

Research output: Contribution to journalReview articlepeer-review

140 Scopus citations

Abstract

The experimental results of prospect theory (PT) reveal suggest that investors make decisions based on change of wealth rather than total wealth, that preferences are S-shaped with a risk-seeking segment, and that probabilities are subjectively distorted. This article shows that while PT's findings are in sharp contradiction to the foundations of mean-variance (MV) analysis, counterintuitively, when diversification between assets is allowed, the MV and PT-efficient sets almost coincide. Thus one can employ the MV optimization algorithm to construct PT-efficient portfolios.

Original languageAmerican English
Pages (from-to)1015-1041
Number of pages27
JournalReview of Financial Studies
Volume17
Issue number4
DOIs
StatePublished - Dec 2004

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