Utility and Portfolio Choice

10232012 p kolm 17 outlook prospect theory and

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Unformatted text preview: ake sense.) RISK AND PORTFOLIO MANAGEMENT WITH ECONOMETRICS, VER. 10/23/2012. © P. KOLM. 16 2. Mean-Variance Optimization If we assume either (a) Security returns {ri } are jointly normally distributed, or (b) The utility function is of the form u(x ) = x − λx 2 Then: the expected utility maximization problem takes the form of the problem in classical portfolio theory, also referred to as mean-variance optimization In the next lecture, we will study this problem in more detail RISK AND PORTFOLIO MANAGEMENT WITH ECONOMETRICS, VER. 10/23/2012. © P. KOLM. 17 Outlook: Prospect Theory and Behavioral Finance • Risk aversion served as one of the central tenets of financial theory until Kahneman and Tversky in 1979 published an influential article in which they demonstrated that people in certain circumstances seek risk rather than avoid it Example (Kahneman and Tversky (1979)) Consider the following choices: A: 80% chance of gaining $4,000 A: 80% 20% chance of gaining nothing B: $3,000 gain for sure Which do you prefer, A or B? chance of losing...
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