One for the Gain, Three for the Loss
SIFR Working Paper No. 20
38 Pages Posted: 12 Mar 2005 Last revised: 6 Feb 2014
Date Written: March 15, 2005
I derive indifference curves in mean-standard deviation space for investors with preferences given by the value function in prospect theory when returns are normally distributed. The normality assumption creates a mapping between model parameters and the investment opportunity set. The model is then calibrated to historical return data for various assumptions regarding the set of admissible risky assets. It is found that the parameter for loss aversion must be higher than three for investors to hold finitely leveraged portfolios. For lower rates of loss aversion, in particular those proposed in the earlier experimental literature, the allocation to risky assets is very high or even infinite. Numerical simulations produce similar results when the normality assumption is abandoned.
Keywords: Investor behavior, portfolio choice, loss aversion
JEL Classification: G11, D8
Suggested Citation: Suggested Citation