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RFS Advance Access published online on October 15, 2003
Review of Financial Studies, doi:10.1093/rfs/hhg062
Review of Financial Studies © The Society for Financial Studies 2003; all rights reserved
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© 2003 The Society for Financial Studies

Original Articles

Prospect Theory and Mean-Variance Analysis

Haim Levy 1 and Moshe Levy 1*
1 Jerusalem School of Business Administration, The Hebrew University, Jerusalem 91905, Israel

* To whom correspondence should be addressed. E-mail: mslm{at}mscc.huji.ac.il.


  Abstract

The extensive experimental results of Prospect Theory (PT) reveal 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 paper shows that while PT's findings are in sharp contradiction to the foundations of mean-variance (M-V) analysis, counter intuitively, when diversification between assets is allowed, the M-V and PT efficient sets almost coincide. Thus, one can employ the M-V optimization algorithm to construct PT efficient portfolios.


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