When Prospect Theory Preference Meets Mean-Reverting Asset Returns: A Dynamic Asset Allocation Model

48 Pages Posted: 30 Apr 2018 Last revised: 31 Oct 2019

See all articles by Jianjun Gao

Jianjun Gao

Shanghai University of Finance and Economics; Shanghai Jiao Tong University

Duan Li

Chinese University of Hong Kong; City University of Hong Kong

Jing Yao

School of Economics, Fudan University

Date Written: October 1, 2017

Abstract

We examine how the evidence of mean-reversion in stock returns affects dynamic trading behavior for investors with prospect-theory preferences. Particular attention is paid to the trading incentives created by the interaction between prospect-theory preferences and mean-reverting return dynamics. Under general assumptions for the continuous-time financial market, we develop the semi-analytical portfolio policy by inverse Fourier Transformation method. By the revealed policy, we find that a small degree of mean reversion can be sufficient to reverse the direction of the investors' trading patterns. Further simulation results demonstrate that the combination of prospect theory and mean reversion can generate the disposition effect close to the data at the reasonable values of the underlying parameters. The results suggest that trading behavior patterns can be seriously misleading if the prospect theory allocation framework ignores time-variation in expected returns such as mean reversion.

Keywords: Prospect Theory, Mean Reversion, Dynamic Asset Allocation, Trading Behavior, Disposition Effect

JEL Classification: G11, C61

Suggested Citation

Gao, Jianjun and Li, Duan and Yao, Jing, When Prospect Theory Preference Meets Mean-Reverting Asset Returns: A Dynamic Asset Allocation Model (October 1, 2017). Available at SSRN: https://ssrn.com/abstract=3161166 or http://dx.doi.org/10.2139/ssrn.3161166

Jianjun Gao (Contact Author)

Shanghai University of Finance and Economics ( email )

No. 100 Wudong Road
Shanghai, Shanghai 200433
China

Shanghai Jiao Tong University ( email )

800 Dongchuan Road
Shanghai
China
+86-18201925139 (Phone)
+86 34205004 (Fax)

Duan Li

Chinese University of Hong Kong ( email )

Shatin, New Territories
Hong Kong

City University of Hong Kong

Tat Chee Avenue
Kowloon Tong
Kowloon
Hong Kong
852 3442 8591 (Phone)

Jing Yao

School of Economics, Fudan University ( email )

600 Guoquan Road
Shanghai, Shanghai 200433
China

HOME PAGE: http://homepage.fudan.edu.cn/yaojing/

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