Prospect Theory and Mean-Variance Analysis

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.