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Empirical Evaluation for U.S. Style Portfolios

Evanthia K. Zervoudi

To cite this article: Evanthia K. Zervoudi (2017): Value Functions for Prospect Theory

Investors: An Empirical Evaluation for U.S. Style Portfolios, Journal of Behavioral Finance, DOI:

10.1080/15427560.2018.1405005

Article views: 11

http://www.tandfonline.com/action/journalInformation?journalCode=hbhf20

Download by: [University of New England] Date: 04 January 2018, At: 22:16

JOURNAL OF BEHAVIORAL FINANCE

https://doi.org/10.1080/15427560.2018.1405005

Value Functions for Prospect Theory Investors: An Empirical Evaluation for U.S.

Style Portfolios

Evanthia K. Zervoudi

Athens University of Economics & Business

ABSTRACT KEYWORDS

The main aim of this article is to provide a general behavioral analysis that proposes a series of Prospect theory; Probability

different value functions for prospect theory (PT) investors incorporated into behavioral reward-risk distortion; S-shaped value

models that are ﬁnally solved so as to provide some speciﬁc optimal solutions. To do this, general function; Loss aversion;

behavioral reward-risk models, which contain all the basic elements of the PT, are ﬁrst set up. Two Behavioral portfolio

optimization; Upper partial

reward and risk measures, the upper partial moment and the lower partial moment, are

Downloaded by [University of New England] at 22:16 04 January 2018

subsequently used to create the various value functions. The technical difﬁculties arising during the moment

behavioral maximization process are overpassed by adapting the Rubinstein [1982] algorithm. The

results show that agents differentiate their behavior according to their type of preferences (S-

shaped, reverse S-shaped, kinked convex, and kinked concave value function) but they seem to

always prefer small capitalization and high positively skewed value stock portfolios. Probability

distortion also affects the optimal solutions of the problem, independently of the employing

weighting functional form; when subjective probabilities are employed the optimal weights of the

most risky positively skewed assets seem to increase. Probability distortion has an additional

important effect on optimal perspective values of the problem driving to a signiﬁcant increase.

Introduction

depending on the loss aversion of the agent. The most

For several years, expected utility theory (EUT) has been representative preference function for this type of invest-

one of the most popular methods in decision-making ors is an S-shaped value function (e.g., a function con-

analysis. EUT models represent rational and totally risk- cave for gains and convex for losses). The importance of

averse investors whose preferences are better described the aforementioned elements of PT in the economic

by an increasing and totally concave utility functions. decision making process has been discussed in several

Uncertainties are expressed in terms of probabilities studies among which Barberis [2013] and Bleichrodt,

(objective and common for all agents) and outcomes in Pinto, and Wakker [2001].

terms of utilities. Many studies, however, demonstrate The main aim of this article is to empirically evaluate

that several deviations from the EUT framework, such as and compare behavioral reward-risk models that contain

probability transformation, loss aversion, scale compati- all the basic elements of PT such as S-shaped value func-

bility, and the prominence effect, take place in practice. tion, loss aversion, and probability distortion. I employ 2

In 1979, Kahneman and Tversky observed that preferen- reward and risk measures, the upper partial moment

ces differ from investor to investor: some agents tend to (UPM) and the lower partial moment (LPM) to create

be risk averse, others risk seeking, and others are neither multiple value functions and the corresponding behavioral

totally risk averse nor totally risk seeking and not even reward-risk models. Their goal is to determine the optimal

consistent with their decision making, although they all asset allocations and the resulting optimal perspective val-

behave rationally in the sense that they prefer more than ues (the values resulting by the value function under con-

less. Based on this observation, they develop the most sideration if the optimal asset allocations are used as

popular alternative to EUT, prospect theory (PT), where weights) for each of these models. The optimization pro-

investors tend to be risk averse for returns considered as cess in a model with nonconcave (and nonconvex) value

gains and risk seeking for returns considered as losses. function, which also has a kinked point at the reference

Gains and losses are determined by a reference point point, differs from the classical optimization method with

CONTACT Evanthia K. Zervoudi zervoudiev@aueb.gr Department of International and European Economic Studies, Athens University of Economics &

Business, Patission 76, Athens, Attica 104 34, Greece.

Color versions of one or more of the ﬁgures in the article can be found online at www.tandfonline.com/hbhf.

© 2017 The Institute of Behavioral Finance

2 E. K. ZERVOUDI

a strictly concave utility function. So, I ﬁrst create an algo- model. I extend this line of research by incorporating

rithm so as to overpass the difﬁculties of maximizing a loss aversion and probability distortion so as to create a

nonconcave and nondifferentiable (at the reference point) general behavioral model that includes all the basic

function. A series of studies, such that of Levy and Levy components of the PT. At the same time I solve this

[2004], De Giorgi and Hens [2009], and Best and Grauer problem to provide speciﬁc optimal solutions, by fol-

[2016], also provide some speciﬁc optimal solutions lowing behavioral optimization methods and maximiz-

resulting from behavioral reward-risk models developed ing the whole value function under the appropriate

in a PT framework. The main aim of these articles is to constraints. This is quite important because by maxi-

make a comparison between the PT and the mean-vari- mizing the whole value function (without separating

ance analysis. Other studies that empirically evaluated PT the analysis into maximization of the UPM or minimi-

models are that of De Giorgi, Hens, and Mayer [2007] zation of the LPM (i.e., I do not differentiate their anal-

and Hens and Vlcek [2011], who examined if the disposi- ysis for outcomes below and above the reference point)

tion effect could be explained by the PT; Pirvu and I take under consideration mixed bets with both posi-

Schulze [2012] made a multistock portfolio selection anal- tive and negative returns which are quite common in

ysis under PT (for stocks that follow multivariate elliptical ﬁnance. However, the maximization of a function that

distributions). The purposes of the present article differ is non–quasi-concave and nonsmooth creates a series

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signiﬁcantly by those papers’ goals. of problems in optimization process that are overpassed

More speciﬁcally, I present original evidence and employing the Rubinstein [1982] algorithm.

contributes to the relevant literature in several ways. Second, I set under examination 5 different value

First, I provide a general behavioral portfolio optimiza- functional forms among which 2 of the most widely

tion model for investors with arbitrary preferences and used functions. More speciﬁcally, I examine the S-

various risk attitudes taking into account higher shaped value function proposed by Kahneman and

moments, such as skewness and kurtosis, which are sig- Tversky [1979], 2 types of the reverse S-shaped value

niﬁcant elements in real market analysis. The ﬁrst main function proposed by Markowitz [1952b], the kinked

component of the model is the value function; to create concave, and the kinked convex value functions. Here it

the value function, I combine the upper partial moment is important to underline that the value function cap-

(as reward measure) and the lower partial moment (as tures the risk and the potential attitude of an investor

risk measure). The article that ﬁrst introduced the LPM and shows how this may change according to the out-

as a risk measure in ﬁnancial models is that of Bawa come of the problem. Employing these 5 value func-

and Lindenberger [1977]. Speciﬁcally, Bawa and Lin- tional forms, I examine how the optimal allocations are

denberger developed a capital asset pricing model differentiated according to the agents’ reward and risk

(CAPM) into a mean-LPM framework and they showed attitudes. As the value functions under consideration are

that when the probability and the portfolio returns dis- not always totally concave (or quasi-concave), the ﬁrst-

tributions are normal, stable, or Student t then the order conditions are necessary but not sufﬁcient which

mean-lower partial moment CAPM is reduced to the means that they can only describe local optima (i.e.,

traditional mean-scale CAPM. After this article, various such a problem may not have a global maximum but

studies employed these reward-risk measures to only local maxima). After that, in each of these value

develop UPM/LPM analyses (see Fishburn [1977], Sor- functions I have incorporated loss aversion that captures

tino, Van der Meer, and Plantinga [1999], Moreno, the psychological phenomenon according to which

Nawrocki, and Olmeda [2006]). Fishburn [1977] pro- investors are more sensitive to losses than to gains. The

posed the LPM model so as to explain the risk-seeking using loss aversion index is that of Kahneman and Tver-

behavior above and the risk-averse behavior below the sky [1979], which is equal to 2.25 (the pain from losses is

reference return; Sortino et al. [1999] proposed as per- more than double than the pleasure from gains). The

formance measure the UPM/LPM ratio to capture more incorporated loss aversion index makes the value func-

realistic investment behaviors while Cumova and tions steeper for losses than for gains, a fact that creates

Nawrocki [2014] developed a general UPM/LPM port- an additional difﬁculty in maximization process.

folio optimization model (see also Moreno, Nawrocki, Third, I take the analysis one step further by using 2

and Olmeda [2006]). Most of these articles follow clas- weighting schemes for the outcomes of the problem; I

sical optimization methods where the LPM is mini- use both linear and nonlinear weighting schemes to

mized under the constraint the UPM to remain above a investigate whether the introduction of probability dis-

target return level or the UPM is maximized under the tortion in the model may affect the empirical results.

constraint the LPM to remain below a target return During the years it has been observed that people do not

level, as Markowitz [1952a] did in his mean-variance weight outcomes linearly but they tend to underestimate

JOURNAL OF BEHAVIORAL FINANCE 3

large and moderate probabilities and overestimate small is introduced in the model especially for agents who fol-

probabilities. The probability distortion captures this low more aggressive strategies. The rest of the article is

underweighting of large and overweighting of small organized as follows: the second section discusses the

objective probabilities, through a nonlinear, continuous, methodology, the third section contains data and empiri-

and strictly increasing probability weighting function. In cal results, and the fourth section concludes the article.

the case of probability distortion each outcome is

weighted by a decision weight that is subjective for each

Methodology

agent and arises from her personal information. There

are various studies where probability distortion and S- UPM/LPM

shaped, concave, and convex value functions are com-

The classical reward-risk model is composed by a reward

bined into one model (see among others Tversky and

measure m and a risk measure r; the tradeoff between

Kahneman [1992], Wu and Gonzalez [1996, 1999], Pre-

reward and risk is given by the utility function, which is

lec [1998], Hens and Vlcek [2011], Best and Grauer

increasing in the reward measure and decreasing in the

[2016]). The role of the probability distortion in the pres-

risk measure. I employ as a reward measure the UPM

ent article is to examine if the optimal solutions of the

measure and as risk measure the LPM measure. The

maximization problem are differentiated using subjective

UPM measure gives the positive deviations of returns

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from a target return. In the model the reference point is

are not due to a speciﬁc probability weighting functional

the risk-free rate. This reference return represents a min-

form, I use 2 weighting functions: (1) Tversky and Kah-

imum target return that an investor requires so as to

neman [1992] and (2) Prelec [1998].

cover her liabilities. These positive deviations in the new

Their results indicate that the value functional form

model are not minimized anymore as in the mean-vari-

does inﬂuence the outcome. Each value function repre-

ance model. Mathematically the UPM is formulated as:

sents a speciﬁc investment strategy; investors who follow

a conservative strategy assign higher weights to less risky

assets and invest smaller percentages of their wealth to X

T

very risky assets. These investors have smaller optimal UPM D pt ½maxð0; rt ¡ rpÞa (1)

tD1

perspective values relatively to investors who follow

aggressive strategies. The most conservative strategy is

that of agents whose preferences are described by a In Equation 1, rt are the assets’ returns, a is the degree

kinked concave value function while the most aggressive of the UPM and rp is the reference point of the model

and the most proﬁtable strategy is that of agents with a (risk-free rate). The parameter a has to do with the

kinked convex value function. This result conﬁrms the investors’ potential attitude. Speciﬁcally:

expectations, as agents with by a kinked concave value a D 1 implies potential neutrality which means that

function are totally risk averse while agents with a kinked an investor is indifferent to an increase or a decrease

convex value function are characterized by (total) risk of the reward.

seeking. Agents with S-shaped and reverse S-shaped a < 1 implies potential aversion which means that

value functions also differentiate the allocation of their the higher the returns above the reference return,

wealth according to their risk and potential attitudes the smaller the satisfaction of an investor.

with potential seekers to follow more aggressive strate- a > 1 implies potential seeking, which means that

gies than potential averse agents. the higher the returns above the reference return,

Probability distortion also inﬂuences empirical results, the greater the satisfaction of an investor.

although the speciﬁc weighting functional form does not The LPM captures only downside deviations from a

play an important role. Optimal asset allocations are benchmark return. Mathematically, the LPM is formu-

affected by probability distortion as follows: positively lated as following:

skewed assets become more attractive to investors when

I assume probability distortion; their weights are X

T

increased remarkably relatively to the other assets, for all LPM D pt ½maxð0; rp ¡ rt Þb (2)

tD1

value functions. However, the allocations are mostly

related to the strategy that an investor follows (deter-

mined by her preferences) and less by the probabilities. In Equation 2, rt are the assets’ returns, b is the degree

The effect of probability distortion is much clearer on of the LPM, and rp is the reference point of the model.

optimal perspective values in the sense that perspective The parameter b has to do with investors’ risk attitude.

values increase signiﬁcantly when probability distortion Speciﬁcally:

4 E. K. ZERVOUDI

b D 1 implies risk neutrality which means that an Regarding the value functions, different combinations

investor is indifferent to an increase or a decrease of of the parameters may lead to several value functional

the risk. forms such as the reverse S-shaped value functions of

b < 1 implies risk seeking (e.g., risk-loving invest- Friedman and Savage [1948] and Markowitz [1952b]

ors), which means that the more the returns fall and the S-shaped value function of PT proposed by Kah-

below the target return, the more investors prefer neman and Tversky [1979]. An important issue is

them. whether the functional form chosen for the analysis

b > 1 implies risk aversion (e.g., risk-averse invest- affects the empirical results. To investigate this issue in

ors), which means that the more the returns fall more detail I employ a number of different value func-

below the target return, the more investors dislike tional forms and the corresponding strategies as follows:

them. a; b > 1: High (above unity) parameter values

imply potential seeking and risk aversion and a

reverse S-shaped value function (concave for losses

Value functions

and convex for gains). I try both the cases where

The utility function of the classical reward-risk model a D b D 1.8 and the case where a D 1.8 and b D

can be represented as: 3.6 (the case where the risk parameter b is higher

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X

T consider protection against losses more important

U ðxÞ D ½½maxð0; rt ¡ rpÞa C ½maxð0; rp ¡ rt Þb (3) than their exposure to gains). Note that these

tD1 parameters are close the ones in Cumova and

Nawrocki [2014] (i.e., a D 2 and b D 4).

PT preferences can be represented as: 0 < a; b < 1: Parameter values between 0 and

unity suggest potential aversion and risk seeking

X

T and an S-shaped value function (concave for gains

Vðrt Þ D w.pt /½½max 0; rt ¡ rp a and convex for losses). This value function is the

tD1

classical PT value function. I use the estimations of

Kahneman and Tversky (i.e., a D b D 0.88).

¡ L½max 0; rp ¡ rt b (4) a > 1 and 0 < b < 1: These values imply both

potential and risk seeking and suggest a value function

In Equation 4, w.pt / are the decision weights that that is in general a kinked convex (because of the

correspond to returns rt 8 t D 1; 2; ::; T (I shall use 2 kinked point at the reference point) value function for

different probability weighting functions), L is the loss both losses and gains. I use as parameters a D 1.8 and

aversion index that takes the value of 2.25 (see Kahne- b D 0.88.

man and Tversky [1979], He and Zhou [2011], among 0 < a < 1 and b > 1: These values imply poten-

others), implying that losses are more than twice painful tial aversion and risk aversion and suggest a kinked

for investors than the pleasure of similar gains. I use the concave value function for both losses and gains

same loss aversion parameter (for all value functional resembling the classical concave function of the

forms) so as to make a direct comparison among the EUT. I use as parameters a D 0.8 and b D 1.88.

optimal allocations of agents who are “equally” loss To weight outcomes 3 approaches are employed: the

averse (have the same loss aversion degree) but they classical linear probability weighting (objective probabili-

have different preferences (i.e., see how the optimal solu- ties) and 2 approaches with probability distortion (Kah-

tions are differentiated according to the value functional neman and Tversky [1992] Prelec [1998]) in which

form under consideration). The evaluation of assets is decision weights (w(p)) subjective for each agent (arising

done by investors according to gains .rt > rp ) and losses from her personal information) are used. The 2 last

.rt < rp ). The ﬁrst part of the value function represents approaches are employed to take into account the proba-

the positive deviations of assets returns from the refer- bility transformation that is a common violation of the

ence point (gains), that is, the reward measure m, EUT, but also ensure that the results are not due to a spe-

whereas the second part represents the negative devia- ciﬁc probability weighting functional form. The experi-

tions of assets’ returns from the reference point (losses), mental outcomes are considered as equally likely. As the

that is, the risk measure r. Having found the optimal analysis is developed into a PT framework, the transfor-

asset allocations, I replace these (optimal) allocations to mation is applied directly on the individual objective

the value function under consideration to ﬁnd the opti- probabilities of the outcomes and not on the cumulative

mal perspective values. ones as in the CPT framework. Thus, the subjective

JOURNAL OF BEHAVIORAL FINANCE 5

probabilities that weight the experimental outcomes will purchase assets whose prices

PNare less or equal to his wealth

be equal and they will be calculated via the subsequent to maximize his welfare i D 1 λi D 1/, and the short-sell-

probability distortion functions by applying the transfor- ing constraint, that the weights of portfolios assets must be

mation directly on the individual objective probabilities. nonnegative (λi 0 8i). In this way, I avoid the case of

The transformation function w() is a nondecreasing inﬁnite leverage and a great risk exposure.

function w : ½0; 1 ! ½0; 1 with wðpÞ > p for small proba- Hence, the asset allocation model is formulated as fol-

bilities and wðpÞ < p for large probabilities while wðpÞ D p lows:

for p D 0 and p D 1. More speciﬁcally, I ﬁrst use the

"" ! !#a

reverse S-shaped probability distortion function proposed X

T X

N

by Tversky and Kahneman [1992], that is: max w.pt / max 0; rit λi ¡ rp

λ

tD1 iD1

pg " !!#b #

wðpÞ D (5) X

N

.pg C ð1 ¡ pÞg /16 g

¡ L max 0; rp ¡ rit λi

iD1

In Equation 5, the parameter g 0.65 determines the

X

N

overweighting of small probabilities and the underweight- s:t: λi D 1

Downloaded by [University of New England] at 22:16 04 January 2018

subjective probabilities that agents give to each event and

it is in accordance with the observation that investors λi 0 8i (7)

tend to overweight small objective probabilities and P

underweight moderate and large objective probabilities. In Equation 7, NiD 1 rit λi D rtT λ is the portfolio

Second, I use the reverse S-shaped probability weight- return at each t D 1…T, rt is the vector of the assets’

ing function proposed by Prelec [1998], where: returns at each t D 1…T, and λ the vector of the assets’

weights. There are several difﬁculties in maximization pro-

wðpÞ D expð ¡ bð ¡ lnpÞÞ~a (6) cess of a behavioral reward-risk model. First, as the value

function is not quasi-concave (and of course not totally

Such a transformation deﬂates the large probabilities concave) the ﬁrst-order condition may only describe local

and inﬂates the small probabilities. The parameter a ~ maxima. Another difﬁculty is that the loss aversion index,

determines the overweighting of small probabilities and which is incorporated in the value function, makes the

the underweighting of large probabilities. Prelec’s proba- objective function nonsmooth and results a nondifferenti-

bility weighting function is a well-behaved probability ability at the reference point. In the case of a piecewise lin-

distortion function, which is regressive, asymmetric, ear value function this problem can easily be dealt with by

reﬂective, and reverse S-shaped (concave for the initial using linear programming. Speciﬁcally, a nonlinear pro-

interval of small probabilities and convex for the proba- gramming problem with a piecewise linear concave func-

bility interval of large probabilities). As the risk aversion tion maximizing under linear constraints can be easily

parameter a ~ decreases the function becomes more reformulated to a linear programming problem using aux-

regressive, more subproportional and more (reverse) S- iliary variables instead of the deviations from the reference

shaped while for a ~ D 1 the weighting function is the point. In the general case of changing risk aversion, which

identity one w.p/ D p. Moreover, Prelec’s weighting is the case of the value functions that I examine in this arti-

function is a 1-parameter subproportional functional cle, several computational issues arise. For example, the

form with a ﬁxed and an inﬂection point at p D 16 e D value function is nonsmooth but it has a kinked point at

0:37 (asymmetric function). The fact that the ﬁxed point the reference point where the value function is nondiffer-

is below the probability 0.5 drives to a decrease of an entiable; here I use smoothing techniques to get around

uncertain outcome’s weight relatively to the certain out- the reference point. Also, the value function is non–quasi-

comes’ weights and thus makes investors more risk concave, which implies that there are upper sets that are

averse for gains and more risk seeking for losses, because nonconvex sets and consequently, the portfolio optimiza-

of the reﬂection. I set b D 1 and a ~ D 0.74, the aggregate tion problem may have several local maxima but not a

least-squares estimations by Wu and Gonzalez [1996]. global solution.

To formulate the asset allocation problem I consider as I follow a process similar to De Giorgi et al. [2006],

λ the vector of the assets’ weights. In this model I assume introducing probability distortion, speciﬁc risk and

N assets in the investor’s portfolio with λi i D 1 ,.., N the reward measures, and different value functional forms.

weight of each asset. The constraints that I impose in the First, the nonsmoothness of the value function is treated

model are the budget constraint, that an agent can using cubic spines. Speciﬁcally, to deal with the

6 E. K. ZERVOUDI

nondifferentiability problem, I replace the nonsmooth the problem. The choice of the n starting points is crucial

value function V(x) by the smooth V~ ðxÞ: for the quality of the solution. I repeat this process by

increasing n until the solution is unchanged (see De Giorgi

~ ðxÞ

V et al. [2007]).

a0 x3 C a1 x2 C a2 x C a3 ; if x 2 ½rp ¡ d; rp C d

D Data and empirical results

V ðx Þ ; elsewhere

(8) For the empirical analysis I employ data on U.S. style

portfolios (stocks listed in on the NYSE, AMEX, and

In Equation 8, d D 10¡6. The goal of this method is to NASDAQ). More speciﬁcally, the sample consists of 10

replace the nonsmooth part of the value function by a canonical decile portfolios formed on size (market equity

smooth and thus differentiable cubic polynomial. I take a [ME]) and 10 decile portfolios formed on value (book to

too small random number d to be as close as possible to market equity ratio [B/M]). All data are available from

the reference point and I approach the nonsmooth part Kenneth French’s online data library. I employ annual

of the value function using cubic splines to make it real returns for the period 1927–2013 (87 years). Table 1

smooth. So, around the reference point the value func- presents descriptive statistics of the sample portfolios.

Downloaded by [University of New England] at 22:16 04 January 2018

tion is replaced by a cubic polynomial, which is now dif- There seems to be an reverse relation between ﬁrm size

ferentiable. The rest of the value function remains the and stock returns, that is, the smaller the market capitali-

same, as away from the reference point the value func- zation of the ﬁrms included in a portfolio is, the larger

tion is smooth and differentiable and thus there is not the portfolios’ return is. Also, for portfolios formed on

problem in maximization process. B/M ratio, the higher the B/M ratio is, the higher the

Thus, the asset allocation model is now formulated as: average return is (i.e., value stocks seems to outperform

!! growth stocks). Small and value stocks seem to have

X

T X

N

higher variance/standard deviation than large and

max ~

w.pt / V rit λi

λ growth stocks, indicating that higher returns may be a

tD1 iD1

compensation for the higher variance (which in general

X

N is considered as a measure of risk for ﬁnancial assets).

s:t: λi D 1 Note, however, that small and value stocks also have

iD1 positive skewness while large and growth stocks are nega-

λi 0 8i (9) tively skewed. This is a quite desirable feature of assets

especially in PT where investor have a clear preference for

The second problem is that the value function is non– positive-skewed assets. More speciﬁcally, if a stock has

quasi-concave, which implies that the portfolio optimiza- positive skewness, investors believe that they have a

tion problem may have several local maxima but not a chance (even a very small one) of becoming very wealthy.

global solution. To overpass this problem I consider N This belief is reinforced by the probability distortion in

starting points that have been randomly generated on the PT where investors tend to overweight too small chances.

P In other words, if positively skewed stocks offer them

unit simplex {λ j N i D 1 λ i D 1, λ i 0 8i}, according to the even a very small chance to have a great return from this

uniform distribution over the unit simplex. I employ the

investment this chance is subjectively distorted and makes

algorithm of Rubinstein [1982] to ﬁnd the optimal alloca-

this investment to be considered as a great opportunity.

tion in their problem. Brieﬂy, this algorithm starts with the

After that, the maximum return that small and value

generation of n pseudorandom numbers (xi 8 i D 1 … n)

stocks may offer is in excess of 100% and too high rela-

according to the uniform distribution on [0, 1], continues

tively to the maximum return of large and growth stocks.

with their transformation to yi D ¡log (xi) 8 i D 1 … n,

This fact may enhance the belief of PT investors that the

corresponding to the exponential distribution with parame-

positively skewed and more proﬁtable small and value

ter 1, and terminates with their normalization as

stocks seems to be a better investment than the negatively

following Pyni corresponding to the uniform distribu-

y

iD1 i

skewed and less proﬁtable large and growth stocks.

tion over the unit simplex. This process is repeated n times. Another article that also points out the preference of PT

Thus, starting from n starting points I get n locally optimal investors to positively skewed stocks is that of Barberis

allocations for each of the value functions which are used and Huang [2008]. Speciﬁcally, authors in their article

to ﬁnd the corresponding optimal perspective values (at study asset pricing issues in a cumulative PT (CPT)

each of these optimal allocations). The allocation with the framework emphasizing the probability transformation

highest perspective value is considered as the solution of feature of CPT and the probability weighting function

JOURNAL OF BEHAVIORAL FINANCE 7

Mean Variance Standard Deviation Kurtosis Skewness Sharpe Ratio Min Max

Small 0.1919 0.1551 0.3939 1.1246 0.7736 0.4871 ¡0.5437 1.4272

Dec 2 0.1711 0.1286 0.3586 3.1056 0.8874 0.4772 ¡0.5553 1.7165

Dec 3 0.1679 0.0992 0.3150 2.5915 0.6410 0.5329 ¡0.5420 1.4776

Dec 4 0.1592 0.0868 0.2946 0.7666 0.3699 0.5405 ¡0.4911 1.1476

Dec 5 0.1539 0.0759 0.2755 1.0778 0.2161 0.5585 ¡0.4788 1.1539

Dec 6 0.1537 0.0679 0.2606 0.6752 0.1021 0.5899 ¡0.4765 1.0141

Dec 7 0.1463 0.0653 0.2554 1.4656 0.1824 0.5727 ¡0.4451 1.0829

Dec 8 0.1369 0.0549 0.2344 1.4449 0.0507 0.5842 ¡0.4716 0.9793

Dec 9 0.1298 0.0471 0.2171 0.6579 ¡0.3904 0.5980 ¡0.5053 0.7136

Large 0.1117 0.0372 0.1929 ¡0.0896 ¡0.4499 0.5788 ¡0.4172 0.4861

Panel B: Portfolios formed on B/M Ratio

Growth 0.1102 0.0507 0.2252 ¡0.4265 ¡0.1836 0.4894 ¡0.4108 0.5829

Dec 2 0.1211 0.0393 0.1983 ¡0.2360 ¡0.2394 0.6106 ¡0.3606 0.5751

Dec 3 0.1186 0.0391 0.1978 0.09036 ¡0.2386 0.5994 ¡0.3886 0.634

Dec 4 0.1215 0.0494 0.2223 2.1081 0.1204 0.5466 ¡0.5239 0.9575

Dec 5 0.1320 0.0507 0.2251 1.9613 ¡0.0407 0.5867 ¡0.6142 0.9126

Dec 6 0.1327 0.0491 0.2215 1.7590 ¡0.1960 0.5988 ¡0.6160 0.7671

Dec 7 0.1343 0.0576 0.2400 1.7269 ¡0.1073 0.5596 ¡0.6318 0.9626

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Dec 9 0.1641 0.0721 0.2686 2.5199 0.4397 0.6112 ¡0.5256 1.2408

Value 0.1751 0.1127 0.3358 1.9364 0.3705 0.5216 ¡0.5799 1.4991

Note. Annual return descriptive statistics on U.S. style portfolios (i.e., 10 canonical decile portfolios formed on size [market equity (ME)]) and 10 decile portfolios

formed on value (book to market equity ratio (B/M)]). All data are available from Kenneth French’s online data library. Sample period: 1927–2013 (87 years).

8 E. K. ZERVOUDI

effects; their main results that an asset’s own skewness Optimal asset allocations

may be (over)priced and that the probability distortion

has a signiﬁcant role in the decision-making process of The following Table 2 presents results for the various

PT investors are in accordance to the results of the pres- value functions when I assume no probability distortion,

ent article, and especially to the ascertainment that PT for size portfolios (panel A) and B/M portfolios (panel

investors prefer positively skewed stocks such as small B). The optimal asset allocation for investors with an S-

and value stocks, a preference that is reinforced by the shaped function is to invest roughly 35% in the smallest

probability distortion (as the too small gain probabilities capitalization portfolio (small portfolio) and roughly

of these assets are overweighted). 53% in high value portfolios (16.42% in decile 8, 22.15%

in decile 9, and 15.51% in the value portfolio). For invest-

ors with a reverse S-shaped function the results indicate

an optimal asset allocation that weighs heavily toward

Value functions the smallest capitalization portfolio. For instance, when

Regarding value functions, Figure 1 presents the different the 2 parameters are equal (a D b D 1.8), agents give the

functions that I obtain with their dataset for various coefﬁ- greatest weight to the small stocks’ portfolio (85.84%)

cient assumptions. As can be seen from the ﬁgure, when and the second larger weight to size decile 2 (9.41%).

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both parameters are set to less than 1 (a D b D 0.88) the When the 2 parameters are not equal (a D 1.8, b D 3.6),

resulting value function is S-shaped (i.e., strictly concave for agents again give the greatest weight to the small stocks’

gains and strictly convex for losses). This type of functional portfolio (87.35%) and the second larger weight to size

form represents agents who tend to be risk averse for out- decile 2 (10.41%). B/M portfolios do not seem to be

comes considered as gains and risk seeking for outcomes important in this case (e.g., the weight of the value port-

considered as losses. When both parameters are set to be folio varies between 0.005% and 0.22%). For a kinked

greater than 1 (a D b D 1.8) the resulting value function is convex value function the 2 smallest size decile portfolios

reverse S-shaped (i.e., strictly convex for gains and strictly have a combined weight of roughly 54% (32.5% and

concave for losses). Such a function represents investors 22.08%), while the value portfolio has a weight of

whose behavior is characterized by risk aversion for losses 11.37%. For the kinked concave function the smallest

and potential seeking for gains. In this case, it makes size portfolio has a weight of 36.76% while the 2 high B/

sense to examine separately what happens when the risk M value portfolios have a combined weight of around

parameter b is higher than the potential parameter a 43% (36.46% for value decile 9 and 6.46% for decile 10).

(a D 1:8 < b D 3:6/ because investor behavior is char- So, in the case where objective probabilities are employed

acterized by risk aversion for losses (i.e., the protection in the model, investors choose to invest the highest pro-

against losses [expressed by the parameter b]) is more portion of their wealth to the riskiest and most proﬁtable

important than the exposure to gains (expressed by the positively skewed small stock portfolio for all types of

parameter a). When the potential parameter a is set to be preferences (i.e., S-shaped, reverse S-shaped, kinked con-

greater than unity and the risk parameter b smaller than vex, and kinked concave value functions). Agents who

unity (a D 1.8 and b D 0.88) then the resulting value func- are potential averse (S-shaped and kinked concave value

tion is a kinked convex function for both losses and gains. function) give smaller weights to this too risky asset

Such a function represents investors whose behavior is char- while potential seekers (reverse S-shaped and kinked

acterized by risk seeking and potential seeking. This type of convex value function) who derive great satisfaction

investors is aggressive enough and is willing to undertake from very high potential, they give higher weights since

great risks by investing to most risky assets that are related this asset has the highest average return.

to high average returns, to derive the greatest possible satis- The following Table 3 presents results for the various

faction (potential seeking). When the potential parameter a value functions when I assume probability distortion and

is smaller than 1 and the risk parameter b is greater than 1 employ the Kahneman and Tversky [1979] weighting

(a D 0.88 and b D 1.8) then the resulting value function is a function, for size portfolios (panel A) and B/M portfolios

kinked concave function for losses and for gains, which (panel B). The optimal asset allocation for investors with

resembles the classical concave value function of the expected an S-shaped function and probability distortion is to

utility theory. Such a function represents a conservative invest 37.49% in the smallest capitalization portfolio and

investor whose behavior is characterized by risk and poten- roughly 47% in value portfolios (34.96% in decile 9 and

tial aversion. This investor is unwilling to undertake great 12.22% in the value portfolio). For investors with a

risks since the satisfaction that she will derive by the addi- reverse S-shaped function the results indicate, as previ-

tional potential won’t be adequate to compensate her great ously, that optimal asset allocation weighs heavily toward

risk exposure (potential aversion). the smallest capitalization portfolio. For instance, when

JOURNAL OF BEHAVIORAL FINANCE 9

Value Function

S-shaped a D 0.88 Reverse S-shaped a D 1.8 Reverse S-shaped a D 1.8 Convex a D 1.8 Concave a D 0.88

b D 0.88 b D 1.8 b D 3.6 b D 0.88 b D 1.8

Small 0.3478 0.8584 0.8735 0.3250 0.3676

Dec 2 0.0078 0.0941 0.1041 0.2208 0.0003

Dec 3 0.0040 0.0170 0.0033 0.1871 0.0009

Dec 4 0.0172 0.0171 0.0020 0.0478 0.0037

Dec 5 0.0103 0.0030 0.0016 0.0064 0.0031

Dec 6 0.0098 0.0007 0.0012 0.0044 0.0033

Dec 7 0.0072 0.0009 0.0014 0.0006 0.0031

Dec 8 0.0035 0.0011 0.0011 0.0046 0.0032

Dec 9 0.0046 0.0008 0.0008 0.0020 0.0029

Large 0.0038 0.0004 0.0005 0.0018 0.0023

Panel B Style Portfolio: B/M Ratio

Growth 0.0023 0.0001 0.0005 0.0020 0.0016

Dec 2 0.0064 0.0005 0.0005 0.0027 0.0018

Dec 3 0.0067 0.0005 0.0007 0.0025 0.0020

Dec 4 0.0031 0.0006 0.0010 0.0035 0.0031

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Dec 6 0.0088 0.0003 0.0006 0.0017 0.0080

Dec 7 0.0017 0.0003 0.0009 0.0019 0.0042

Dec 8 0.1642 0.0003 0.0015 0.0024 0.1523

Dec 9 0.2215 0.0029 0.0018 0.0588 0.3646

Value 0.1551 0.0005 0.0022 0.1137 0.0646

Optimal value 0.2252 0.1740 0.2040 0.2770 0.1590

Note. Optimal asset allocations for value functions without probability distortion and for various assumptions about the coefﬁcients. The sample consists of U.S.

style portfolios (i.e., 10 canonical decile portfolios formed on size [market equity (ME)]) and 10 decile portfolios formed on value (book to market equity ratio [B/

M]). All data are available from Kenneth French’s online data library. Sample period: 1927–2013 (87 years).

the 2 parameters are equal (a D b D 1.8), agents give the are not equal. For a kinked convex value function the 2

greatest weight to the small stocks’ portfolio (88.25%) smallest size decile portfolios have a combined weight of

and the second larger weight to size decile 2 (10.48%); roughly 60% (39.85% and 21.56%), whereas the value

the same happens when I assume that the 2 parameters portfolio has a weight of 15.8%. For the kinked concave

Table 3. Optimal asset allocation: Kahneman and Tversky [1992] weighting function.

Value Function

S-shaped a D 0.88 Reverse S-shaped a D 1.8 Reverse S-shaped a D 1.8 Convex a D 1.8 Concave a D 0.88

b D 0.88 b D 1.8 b D 3.6 b D 0.88 b D 1.8

Small 0.3749 0.8825 0.8809 0.3985 0.3830

Dec 2 0.0012 0.1048 0.1058 0.2156 0.0000

Dec 3 0.0080 0.0004 0.0002 0.0018 0.0026

Dec 4 0.0069 0.0013 0.0021 0.1079 0.0015

Dec 5 0.0023 0.0010 0.0006 0.0036 0.0012

Dec 6 0.0013 0.0010 0.0006 0.0224 0.0016

Dec 7 0.0008 0.0009 0.0005 0.0035 0.0016

Dec 8 0.0104 0.0008 0.0004 0.0067 0.0020

Dec 9 0.0084 0.0004 0.0008 0.0059 0.0020

Large 0.0096 0.0004 0.0008 0.0028 0.0011

Panel B Style Portfolio: B/M Ratio

Growth 0.0086 0.0004 0.0004 0.0061 0.0007

Dec 2 0.0097 0.0004 0.0006 0.0054 0.0010

Dec 3 0.0075 0.0005 0.0007 0.0039 0.0019

Dec 4 0.0100 0.0006 0.0008 0.0030 0.0014

Dec 5 0.0174 0.0008 0.0006 0.0023 0.0062

Dec 6 0.0091 0.0001 0.0007 0.0013 0.0197

Dec 7 0.0031 0.0006 0.0006 0.0035 0.0022

Dec 8 0.0391 0.0008 0.0012 0.0174 0.1291

Dec 9 0.3496 0.0012 0.0012 0.0304 0.3919

Value 0.1222 0.0011 0.0006 0.1580 0.0493

Optimal Value 0.7023 0.5949 0.7100 0.8620 0.2233

Note. Optimal asset allocations for value functions with probability distortion (Kahneman and Tversky [1992]) and for various assumptions about the coefﬁcients.

The sample consists of U.S. style portfolios (i.e., 10 canonical decile portfolios formed on size [market equity (ME)]) and 10 decile portfolios formed on value

(book to market equity ratio (B/M)]). All data are available from Kenneth French’s online data library. Sample period: 1927–2013 (87 years).

10 E. K. ZERVOUDI

function the smallest size portfolio has a weight of 38.3% kinked concave value functions) with potential averse

whereas the 2 high B/M value portfolios have a com- agents to give smaller weights to this too risky asset than

bined weight of around 44% (39.19% for value decile 9 potential seekers.

and 4.93% for decile 10). Overall, the results in this subsection indicate that dif-

The results for the case in which I assume probability ferent value functions result to different optimal asset

distortion and employ the Prelec [1998] weighting func- allocations: all value functions suggest a higher weighting

tion are presented in Table 4 and indicate that the choice for small capitalization ﬁrms compared with value ﬁrms;

of the weighting function does not matter much for the particularly the reverse S-shaped functions suggest a sig-

optimal asset allocation. In other words the results in niﬁcantly higher weighting for small ﬁrms. Also, proba-

Table 4 are qualitatively similar to the results in Table 3. bility distortion seems to play a role in the sense that it

For instance, the optimal asset allocation for investors results an increase of extreme style portfolios’ weights

with an S-shaped function is to invest about 40% (small-cap and high B/M); however, the exact weighting

(37.49% in Table 3) in the smallest capitalization portfo- functional form does not play a substantial role. The

lio and roughly 45% (47% Table 3) in value portfolios; results indicate that PT investors believe that investing to

for investors with an reverse S-shaped function the a positively skewed asset has a chance (a very small one)

results indicate that optimal asset allocation weighs to produce very high returns with high risk; thus they

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heavily toward the smallest capitalization portfolio; for a assign the highest weight to the most proﬁtable and posi-

kinked convex value function the 2 smallest size decile tively skewed asset (small stock portfolio). When proba-

portfolios have a combined weight of roughly 57% (from bility distortion is incorporated in the model, the very

60% in Table 3); for the kinked concave function the small probabilities are overweighed, making such a risky

smallest size portfolio has a weight of 41.84% (from asset to seem even more attractive. This suggests that

38.3% in Table 3) while the 2 high B/M value portfolios probability distortion affects decisions (without altering

have a combined weight of around 42% (from 44% in the clear preference to positively skewed assets) driving

Table 3). As in the case of nonprobability distortion, investors to further increase the percentage of their

agents choose to invest the highest proportion of their wealth invested to positively skewed assets and especially

wealth to the riskiest and most proﬁtable positively to the small-stock portfolio that offers very high average

skewed small stock portfolio for all types of preferences returns. These results (Tables 2–4) are also summarized

(i.e., S-shaped, reverse S-shaped, kinked convex, and graphically in Figures 2–6.

Value Function

S-shaped a D 0.88 Reverse S-shaped a D 1.8 Reverse S-shaped a D 1.8 Convex a D 1.8 Concave a D 0.88

b D 0.88 b D 1.8 b D 3.6 b D 0.88 b D 1.8

Small 0.3999 0.8518 0.8790 0.4003 0.4184

Dec 2 0.0038 0.1083 0.1061 0.1681 0.0009

Dec 3 0.0100 0.0042 0.0004 0.0819 0.0419

Dec 4 0.0045 0.0222 0.0047 0.0506 0.0022

Dec 5 0.0029 0.0039 0.0006 0.0021 0.0018

Dec 6 6.5462 0.0006 0.0005 0.0096 0.0030

Dec 7 0.0019 0.0006 0.0005 0.0119 0.0032

Dec 8 0.0012 0.0006 0.0005 0.0133 0.0075

Dec 9 0.0006 0.0005 0.0005 0.0149 0.0067

Large 0.0008 0.0006 0.0009 0.0060 0.0018

Panel B Style Portfolio: B/M Ratio

Growth 0.0008 0.0003 0.0007 0.0090 0.0038

Dec 2 0.0011 0.0003 0.0006 0.0131 0.0021

Dec 3 0.0008 0.0005 0.0007 0.0143 0.0046

Dec 4 0.0011 0.0003 0.0008 0.0130 0.0041

Dec 5 0.0023 0.0004 0.0005 0.0226 0.0051

Dec 6 0.0002 0.0004 0.0009 0.0172 0.0190

Dec 7 0.0003 0.0004 0.0005 0.0090 0.0025

Dec 8 0.1216 0.0006 0.0006 0.0003 0.0457

Dec 9 0.3828 0.0030 0.0971 0.0382 0.3336

Value 0.0633 0.0006 0.0008 0.1045 0.0921

Optimal Value 0.6067 0.5109 0.6477 0.8451 0.2225

Note. Optimal Asset Allocations for value functions with probability distortion (Prelec [1998]) and for various assumptions about the coefﬁcients. The sample con-

sists of U.S. style portfolios (i.e., 10 canonical decile portfolios formed on size (market equity, ME) and 10 decile portfolios formed on value (Book to Market

Equity ratio, B/M). All data are available from Kenneth French’s online data library. Sample period: 1927–2013 (87 years).

JOURNAL OF BEHAVIORAL FINANCE 11

Figure 2. Optimal asset allocation for the S-shaped value function.

function.

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function.

Figure 3. Optimal asset allocation for the reverse S-shaped value

function (a).

reverse S-shaped, kinked convex, and kinked concave

value function). I obtain these optimal values as follows:

in the optimization process I employed 700 initial points

for each of the value functions; for every initial point I

obtained an optimal asset allocation and its correspond-

ing optimal perspective value through the asset allocation

model (9) and I reported the highest optimal perspective

value as the solution of the optimization problem (for

each of the value functions). Figure 8 presents a sum-

mary of these results. Their goal is to see how the optimal

perspective values are differentiated according to invest-

Figure 4. Optimal asset allocation for the reverse S-shaped value ors’ reward and risk attitudes represented by a speciﬁc

function (b). value function. Thus, for the S-shaped function (a D

0.88 and b D 0.88) the optimal value is around 20%

Overall, the ﬁndings in this section indicate that (1) agents without probability distortion, around 70% with the

give the maximum weight to the smallest stock portfolio; (2) Kahneman and Tversky [1979] weighting function, and

the second larger weight is given to high value stocks; (3) around 60% with the Prelec [1998] weighting function.

when probability distortion is incorporated in the model it For the reverse S-shaped functions the optimal value is

seems that the very small probabilities are overweighted, around 20% without probability distortion, around 60–

making risky positively skewed assets (and especially the 70% with the Kahneman and Tversky [1979] weighting

small-stock portfolio) to seem more attractive; and (4) the function, and around 50–60% with the Prelec [1998]

used weighting function is of second importance. weighting function. For the kinked convex function (a D

1.8 and b D 0.88) the optimal value is around 85% with

and 28% without probability distortion, whereas for the

Perspective value

kinked concave value function (a D 0.88 and b D 1.8)

Figure 7 presents the optimal perspective values obtained the optimal value is around 16% without and 22% with

for the different value functions of this article (S-shaped, probability distortion.

12 E. K. ZERVOUDI

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As I see there are signiﬁcant differentiations among assets, which are related to highest average returns, to

the optimal perspective values from one value func- derive the greatest possible satisfaction (potential

tion to the other. The lowest optimal perspective val- seeking).

ues are obtained for the kinked concave value The probability distortion is another important factor

function. The reason behind this is that this strategy that also affects the optimal perspective values. This is so

is the least risky (i.e., agents with this type of prefer-

ences (totally risk and potential averse investors) are

the most conservative and prefer to invest higher per-

centages of their wealth to less risky assets, which are

related to lower average returns, to reduce their risk

exposure (risk and potential aversion); in this way

they sacriﬁce a part of their potential returns lowering

their optimal perspective values, as well. As expected,

the highest values are obtained for the kinked convex

value function. The reason behind this is that this is

the most risky strategy, that is, agents with this type

of preferences (totally risk and potential seeking

investors) are the most aggressive and prefer to invest Figure 8. Comparison of optimal perspective values for different

higher percentages of their wealth to most risky value functions.

JOURNAL OF BEHAVIORAL FINANCE 13

because the objective probabilities that weight the out- value functions, with and without probability distortion.

comes of the problem are too small, lowering in this way The fact that the optimal perspective values are much

the resulting perspective values. When probability distor- higher than the 2 benchmarks in all cases implies that PT

tion is introduced, these very small probabilities are over- investors whose preferences are described by the value

weighed increasing directly the optimal perspective functions examined in this article (S-shaped function,

values. After that, the overweighting of very small objec- reverse S-shaped functions, kinked convex function, and

tive chances to become very wealthy by investing to posi- kinked concave function) choose strategies that are highly

tively skewed assets makes these assets more attractive to proﬁtable and achieve returns considerably above the aver-

agents driving them to increase their weights in their port- age market return as it is expressed by the average risk-free

folios, but the positively skewed assets are also related to rate and the average excess return on the market portfolio.

high average returns which implies a signiﬁcant increase Note here that such a rate is often the benchmark return

to the optimal perspective values, as well. (the pursuit) for classical risk-averse agents. This implies

The analysis is completed by comparing the optimal that PT investors differentiate their behavior, choosing to

perspective values resulting by all value functions to 2 follow more risky but also much more proﬁtable strategies

benchmarks: (1) the average risk-free rate for the period to derive a great satisfaction in terms of utility. This ﬁnding

under examination 1927–2013 that is equal to 3.5% and may be ampliﬁed by the fact that PT agents have a clear

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(2) the average excess return on the market portfolio for preference to positively skewed stocks that are considered

the same period 1927–2013 that is equal to 4.8%. The as quite proﬁtable assets and thus may drive to great poten-

choice of these 2 benchmarks is justiﬁed by the fact that tial returns and very high optimal perspective values.

PT investors quite often use these rates (the average risk-

free rate and the average excess return on the market port-

folio) as reference points to evaluate their portfolios. The

Conclusions

results show that the optimal perspective values are much

higher than the 2 benchmarks in all cases. This ﬁnding In this article, I built a general behavioral reward-risk model

becomes more conspicuous when probability distortion is that contains all the basic elements of the PT. I used 2 reward

introduced in the model. More speciﬁcally, the lowest and risk measures, the UPM and the LPM, to create different

optimal perspective values obtained for the kinked con- value functions for their problem that I solved by maximiz-

cave value function is around 16% without and 22% with ing the resulting value functions under the budget and the

probability distortion (i.e., more than 4 times higher than short-selling constraints. I ﬁnd that when agents are potential

the average risk-free rate 3.5% without probability distor- seekers and their preferences are represented by a reverse S-

tion and more than 6 times higher than the average risk- shaped or by a kinked convex value function, they assign

free rate 3.5% with probability distortion. Similarly, the much higher weights (almost 86%) to the small size portfolio

optimal perspective values obtained for the least risky (the riskiest and most proﬁtable positively skewed asset). In

strategy, representing by the kinked concave value func- addition, they assign the second larger weight to the decile 2

tion, are more than 3 times higher than the average excess portfolio formed on size, which is the second riskiest and

return on the market portfolio without probability distor- second most proﬁtable positively skewed asset. In other

tion and more than 4 times higher than the average excess words, potential seekers follow very aggressive strategies and

return on the market portfolio with probability distortion. invest almost all of their wealth in only 2 very risky and very

The differentiations are impressive if we compare the opti- proﬁtable assets to increase their potential and thus derive a

mal perspective values obtained for the most risky strat- great satisfaction. The strategy is also consistent with the

egy, representing by the kinked convex value function, to clear preference of PT investors to positively skewed assets,

the 2 benchmarks (i.e., more than 8 times higher than the which are quite risky but they offer the (small) chance of sig-

average risk-free rate without probability distortion and niﬁcant returns. When preferences are represented by an S-

more than 24 times higher than the average risk-free rate shaped or a kinked concave value function, potential averse

with probability distortion. Similarly, the highest optimal investors follow more conservative strategies without altering

perspective values are more than 5 times higher than the their clear preference to the positively skewed assets. In these

average excess return on the market portfolio without cases, agents allocate the greatest part of their wealth among

probability distortion and more than 17 times higher than the small stocks’ portfolio (about 36%) and the high-value

the average excess return on the market portfolio with portfolios (about 38% in the 2 highest value deciles). This

probability distortion. strategy is less aggressive than the strategy of potential

The reason for this comparison is to give an economic seekers in the sense that potential averse investors choose to

meaning to the comparative analysis of the optimal alloca- invest to more and less risky (but always positively skewed)

tions and the resulting optimal perspective values for all assets to reduce their risk exposure.

14 E. K. ZERVOUDI

Probability distortion seems to affect the optimal asset general behavioral reward-risk models that are solved

allocations, but it does not alter at all the clear preference under the appropriate constraints. This analysis is devel-

of PT investors to positively skewed assets, independently oped into a PT framework similar to the studies of Best

of the employing weighting functional form. In fact, when and Grauer [2016] and Pirvu and Schulze [2012] that,

subjective probabilities are employed the optimal weights however, are in a different direction; these studies mostly

of the most risky positively skewed assets increase. This focused on the optimization process of a PT model under

takes place because the objective probabilities for an agent the appropriate constrains and subsequently to the com-

to become very wealthy by investing to a quite risky posi- parison of the resulting solutions with that of the classical

tively skewed asset are too small. But, when probability mean-variance problem. One interesting issue for future

distortion is incorporated in the model, the very small research would be the development of the present behav-

probabilities are overweighted making this asset more ioral analysis into a CPT framework. The main differenti-

attractive to investors and driving them to increase the ation between PT and CPT is that in the PT framework

percentages of their wealth that they invest to this asset. In the experimental outcomes are equally likely because the

general, probability distortion increases the attractiveness transformation is applied directly on the individual objec-

of the positively skewed assets, driving investors to tive probabilities of the outcomes whereas in the CPT

increase the weight that they give to these assets, indepen- framework equally likely outcomes may take different

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dently of the employing weighting functional form. probability weights because the transformation is applied

Finally, probability distortion has a signiﬁcant effect on on the cumulative probabilities rather than on the individ-

optimal perspective values; without probability distortion ual ones (see Tversky and Kahneman [1992], Wakker and

the optimal perspective values are much lower than the Tversky [1993], among others). In this direction are the

optimal perspective values with probability distortion. working article “Theory Matters for Financial Advice!” of

This happens because without probability distortion the Hens and Mayer [2014b] and especially the working arti-

objective probabilities, which weight the outcomes are too cle “Cumulative Prospect Theory and Mean Variance

small while with probability distortion the small probabili- Analysis: A Rigorous Comparison” of Hens and Mayer

ties are overweighted, and thus the perspective values [2014a] in which algorithms for optimization into a CPT

increase signiﬁcantly. The lowest optimal perspective framework are presented, the probability distortion is

value (around 20% with probability distortion) is observed applied on cumulative rather than on individual probabili-

in the case of the kinked concave value function, which ties while it is taken into account the additional non-

represents more conservative investors (large weights are smoothness that is introduced in the model because of the

assigned to the less risky assets) and the highest optimal sorting of scenarios.

perspective value (around 85% with probability distor- Two basic issues would make interesting the develop-

tion) is observed in the case of the kinked convex value ment of the present behavioral analysis into a CPT

function which represents the most aggressive investors framework. The ﬁrst main issue is that models developed

(large weights are assigned to the most risky assets). High into a CPT framework may avoid the violation of the

optimal perspective values are also obtained in the case of ﬁrst-order stochastic dominance rule, which practically

the reverse S-shaped value function, which represents means that PT investors may choose dominated strate-

risk-averse and potential seeking investors; the weight that gies. However, there are studies such that of Rieger and

these investors give to the very proﬁtable small stocks Wang [2008], which support that the violation of the

portfolio is very high (around 86%), resulting quite large ﬁrst order stochastic dominance rule is not necessarily a

returns. This is due to the potential-seeking attitude, problem because in descriptive decision-making theories

which makes agents to be willing to undertake greater such as the PT, investors often choose dominated strate-

risks to have higher returns and thus greater satisfaction. gies. Even if the most economic theories preassume

On the other hand, in the case of the S-shaped value func- rational investors, the theory of Kahneman and Tversky

tion, which represents risk seeking and potential averse [1979] does not adopt this traditional assumption of

investors, the optimal perspective values are smaller agents’ rationality because it is considered at most a

because the potential aversion attitude makes agents descriptive theory and not a normative one. The second

unwilling to undertake high risks, lowering in this way issue is that the PT is not continuous (i.e., small changes

their optimal perspective values. In general, the riskier the in lotteries can drive to great changes in PT value). The

strategy is, the higher the optimal perspective values are, problem arises from the fact that the PT is applied only

with and without probability distortion. on lotteries with small number of outcomes and on dis-

It would be useful here to point out that this article is a crete distributions. The CPT could offer a solution to

general behavioral analysis that proposes a series of differ- this problem since the CPT is applied on lotteries with

ent value functions for PT investors incorporated into any number of outcomes. However, as the number of the

JOURNAL OF BEHAVIORAL FINANCE 15

outcomes goes to inﬁnity, the limit of the continuous dis- Gonzalez, R., and G. Wu. “On the Shape of the Probability Weight-

tributions becomes independent of speciﬁc weighting ing Function.” Cognitive Psychology, 38, (1999), pp. 129–166.

functional forms. In this way, an analysis developed into He, X. D., and X. Y. Zhou. “Portfolio Choice under Cumulative

Prospect Theory: An Analytical Treatment.” Management

a PT framework becomes computationally less costly Science, 57, (2011), pp. 315–331.

than an analysis developed into a CPT framework. This Hens, T., and J. Mayer. “Cumulative Prospect Theory and

simpliﬁcation offers a signiﬁcant advantage to the PT (or Mean Variance Analysis: A Rigorous Comparison.”

the smooth PT), especially in behavioral ﬁnance where (2014a). Swiss Finance Institute Research Paper No. 14–23,

the amounts of data (e.g., historical stock returns are forthcoming to Journal of Computational Finance.

Hens, T., and J. Mayer. “Theory Matters for Financial Advice!”

huge, comparing to the CPT that is numerically and ana-

(2014b). Swiss Finance Institute Research Paper No. 14–22,

lytically costly. From all these, it becomes clear that both RR for Journal of Computational Finance.

behavioral analyses developed into a PT framework and Hens, T., and M. Vlcek. “Does Prospect Theory Explain the

a CPT framework are quite important and interesting. Disposition Effect?” Journal of Behavioral Finance, 12,

(2011), pp. 141–157.

Kahneman, D., and A. Tversky. “Prospect Theory: An Analysis of

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