Abstract
Purpose – The purpose of this paper is to empirically test dominant theories and assumptions in behavioral finance, using data from the Standard & Poor’s 500 index.
Design / methodology / approach – The empirical analysis has three parts: to test the assumption of risk aversion; to examine the dominant theory that the optimal portfolio depends on risk preferences; and to test prospect theory that decision makers prefer certain outcomes over probable outcomes. Finally, an alternative model to test prospect theory is introduced.
Findings – The proposed model is more flexible than prospect theory since it does not a priori assume what value of the portfolio induces risk aversion/seeking, while it does not a priori preclude linear preferences. Empirical results show that: investors are risk seeking; a change in the sign of preferences does not necessarily imply a change in the sign of wealth/return and vice versa; and the optimal portfolio does not depend on preferences. Practical implications – These findings are helpful to risk managers dealing with models of behavioural finance.
Originality / value – The contribution of this paper is that it successfully tests fundamental theories and assumptions in behavioral finance by providing a better alternative to prospect theory in several ways.
Original language | English |
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Pages (from-to) | 262-268 |
Number of pages | 7 |
Journal | The Journal of Risk Finance |
Volume | 13 |
Issue number | 3 |
DOIs | |
Publication status | Published - 2012 |