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A Behavioral Foundation of Reward-Risk Portfolio Selection and the Asset Allocation PuzzleEnrico G. De GiorgiUniversity of St. Gallen - SEPS: Economics and Political Sciences Thorsten HensDepartment of Banking and Finance; Norwegian School of Economics and Business Administration (NHH); Swiss Finance Institute (Zurich Center) Janos MayerUniversity of Zurich - Institute of Business Administration June 10, 2008 EFA 2006 Zurich Meetings Paper Abstract: In this paper we suggest a behavioral foundation for the reward-risk approach to portfolio selection based on prospect theory. We identify sufficient conditions for two-fund separation in reward-risk models in general, and for the behavioral reward-risk model in particular. It is shown that a prospect theory investor with piecewise-power function satisfies two-fund separation if the reference point is the risk-free rate, while two-fund separation fails if the reference point is higher than the risk-free rate. We derive a multiple-account version of the behavioral reward-risk model and we perform an empirical analysis on U.S. data to show that this model explains the asset allocation puzzle.
Number of Pages in PDF File: 65 Keywords: Portfolio selection, asset allocation puzzle, prospect theory, coherent risk measures, mental accounting JEL Classification: G11, D81 working papers seriesDate posted: May 3, 2006 ; Last revised: June 11, 2008Suggested CitationContact Information
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