Investors Facing Risk : Prospect Theory and Non-Expected Utility in Portfolio Selection

This paper focuses on the attitude of non-professional investors towards financial losses and their decisions on wealth allocation, and how these change subject to behavioral factors. Our contribution concerns the integration of behavioral elements into the classic portfolio optimization. Individual perceptions are modeled according to an extended prospect-theory framework: Losses loom larger than gains of the same size (loss aversion) and the past risky-portfolio performance changes the subjective valuation of risky investments. The utility of financial investments is overemphasized (myopia). The portfolio model with individual VaR delivers an optimal wealth assignment between risky and risk-free assets