Testing dominant theories and assumptions in behavioral finance

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.