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
Date Written: October 1, 2017
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: Suggested Citation