A Behavioral Foundation of Reward-Risk Portfolio Selection and the Asset Allocation Puzzle

In this paper we suggest a behavioral foundation for the reward-risk approach to portfolio selection based on prospect theory. We identify sufficient conditions for mutual fund separation in reward-risk models in general and for prospect theory in particular. It is shown that a prospect theory investor satisfies mutual fund separation if the reference point is the risk-free rate. For other reference points mutual fund separation fails for the prospect theory reward-risk model and, as we will show, prospect theory can explain the asset allocation puzzle.