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RFS Advance Access originally published online on October 15, 2003
Review of Financial Studies 2004 17(4):1015-1041; doi:10.1093/rfs/hhg062
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The Review of Financial Studies Vol. 17, No. 4 © 2004 The Society for Financial Studies; all rights reserved.

Prospect Theory and Mean-Variance Analysis

Haim Levy
Hebrew University

Moshe Levy
Hebrew University

Address correspondence to Haim Levy, Jerusalem School of Business Administration, The Hebrew University, Jerusalem 91905, Israel, or e-mail: mshlevy{at}mscc.huji.ac.il

The experimental results of prospect theory (PT) reveal suggest that investors make decisions based on change of wealth rather than total wealth, that preferences are S-shaped with a risk-seeking segment, and that probabilities are subjectively distorted. This article shows that while PT's findings are in sharp contradiction to the foundations of mean-variance (MV) analysis, counterintuitively, when diversification between assets is allowed, the MV and PT-efficient sets almost coincide. Thus one can employ the MV optimization algorithm to construct PT-efficient portfolios.


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