Prospect theory and portfolio selection

Abstract

We examine prospect theory portfolios in asset allocation settings that include riskfree lending and borrowing, subject to margin constraints, and short sales restrictions on risky assets. In static settings, we focus on myopic loss aversion, which assumes loss averse investors are willing to take more risk if they evaluate their investment performance infrequently. The results show the portfolios, including those of the investor with a loss aversion coefficient of 2.25, are extremely unstable across decision horizons. In dynamic settings, the portfolios of investors with loss aversion on the order of two perform well. But in some instances the house money effect, where the position of the kink and the investor’s loss aversion changes with gains and losses, has a large negative impact on the wealth of these investors.