Prospect Theory and Asset Allocation

We study the asset allocation of an investor with prospect theory (PT) preferences. First, we solveanalytically the two-asset problem of the PT investor for one risk-free and one risky asset and find thatloss aversion and the reference return affect differently less ambitious and more ambitious investors.Second, we empirically investigate the performance of a PT portfolio when diversifying among a stockmarket index, a government bond and gold, in Europe and the US. We focus on investors with PTpreferences under different scenarios regarding the reference return and the degree of loss aversionand compare their portfolio performance with the performance of investors under mean-variance (MV),linear loss averse and CVaR preferences. We find that, in the US, PT portfolios significantly outperformMV portfolios (in terms of returns) in most cases. Finally, we analyze asymmetric effects along economicuncertainty and obtain similar findings in times of high uncertainty