We present an overview of behavioral finance’s consistent role in portfolio theory and market theory through utility theory. Since Bernoulli, the subjective nature of utility has been increasingly generalized for questionable purposes. Behavioral finance is reverting back to the original intents of utility theory. We also examine the statistical methods used to determine their suitability for the task at hand. Given the heterogeneous population at the market and individual security level, we suggest that nonparametric nonlinear statistics are best suited for descriptive and inferential analysis of all possible investor preferences.

We propose a bifurcation model of market returns to describe transitions between an 'over-reaction' mean regressive state and 'under-reaction' trend persistent states. Since July 1929, the Dow Jones Industrial Average has exhibited non-stationary state transition behavior, including: (1) mean regressive behavior during crisis situations during the Great Depression of the 1930s and again in the crisis of 2008 when the availability of credit was interrupted; (2) strongly bifurcated, or trend persi...

The lower partial moment (LPM) has been the downside risk measure that is most commonly used in portfolio analysis. Its major disadvantage is that its underlying utility functions are linear above some target return. As a result, the upper partial moment (UPM)/lower partial moment (LPM) analysis has been suggested by Holthausen (1981. American Economic Review, v71(1), 182), Kang et al. (1996. Journal of Economics and Business, v48, 47), and Sortino et al. (1999. Journal of Portfolio Management, ...

The utility of an investor should be based on an acceptable loss in the loss region and a target return in the gain region of a set of investment opportunities. The level of these benchmarks will unveil an opportunity cost, break-even effect, or indifference when the return of an investment equals zero. This condition has been arbitrarily assumed away for continuity and other simplification purposes over the past few decades. Historically, utility functions, Von Neumann–Morgenstern compliant and...

Gaps between optimized portfolios produced by mean-variance optimizers and portfolios that investors prefer come from two sources. One is imprecise estimates of mean-variance parameters. The other is investor preferences beyond high expected returns and low risk. We offer the mean-variance ‘efficient range’ as the location of all mean-variance efficient portfolios that acknowledge imprecise estimates and accommodate investor preferences.

PART 1- The Current Paradigm: MPT (Modern Portfolio Theory) Chapter 1: Modern Portfolio Theory as it Stands Chapter 2: Challenges to MPT: Theoretical-the assumptions are not thus Chapter 3: Challenges to MPT: Empirical-the world is not thus Chapter 4: Challenges to MPT: Behavioural-people are not thus Chapter 5: Describing the Overall Framework: Investors and Investments PART 2- Amending MPT: Getting to BMPT Chapter 1:Investors-The Rational Investor Chapter 2: Investments-Extracting Value from t...

Utility should be a function consisting of two autonomous sections both positive and negative, that needs to be configurable to the individuals it is designed to represent. This is achieved through the target by which individuals measure their investments against as well as their individual interpretations of target variances. Historical utility functions tend to generalize these distinctions in order to apply them to a broader scope of the population and project a descriptive theory. Instead of...

While the semivariance (lower partial moment degree 2) has been variously described as being more in line with investors' attitude towards risk, implementation in a forecasting portfolio management role has been hampered by computational problems. The original formulation by Markowitz (1959) requires a laborious iterative process because the cosemivariance matrix is endogenous and a closed form solution does not exist. There have been attempts at optimizing an exogenous asymmetric cosemivariance...

This essay summarizes my views on (a) the foundations of portfolio theory and its applications to current issues, such as the choice of criteria for practical risk-return analysis, and whether some form of risk-return analysis should be used in fact; (b) hypotheses about actual financial behavior, as opposed to idealized rational behavior, including two proofs of the fact that expected-utility maximizers would never prefer a multiple-prize lottery to all single-prize lotteries, as asserted in on...

Assumptions about the importance of the organization and the possibility of studying for a long time economists have greeted with skepticism. Of course, there were the happy exceptions, such as in the works of Alfred Marshall, Joseph Schumpeter, Friedrich Hayek. In favor of the importance of the organization expressed equally and representatives of economic institutionalism (Thorsten Veblen, John Commons and K. Ronald Coase), and representatives of the organization theory (Robert Michelz, Cheste...

(Radboud University Nijmegen)+ 1 AuthorsJuan M. Gómez (ICESI University)

Abstract Modern financial theory relies on the rationality assumption of investors even though, evidence suggests that market investors are affected by behavioural biases such as overconfidence and disposition effect. Overconfident investors perceive situations better than what they actually are, while investors exhibiting disposition effect tend to dispose winner shares and keep loser ones. However there is not clear causal relationship between both biases. We contribute to the literature about...

(CUNY: City University of New York), Giora Harpaz5

Estimated H-index: 5

(CUNY: City University of New York)

The paper reviews the development of von Neumann and Morgenstern (vNM) utility theory. Kahneman and Tversky’s (KT’s) prospect theory is introduced. The vNM utility function is compared and contrasted with KT’s value function. We prove the uniqueness of two popular utility functions. First, we show that all power utility functions possess constant RRA. And, we show that all exponential utility functions have constant ARA. The paper concludes by discussing applications, strengths and weaknesses of...

This article provides an alternative theoretical framework to explain investors’ irrational behaviours in finance theories (mainly asset pricing) based on psychoanalysis approach. This is an approach used by psychoanalysts and psychiatrists to investigate human minds. The investigation is facilitated by interdisciplinary theories, namely (a) bounded rationality theory which differentiates intuition and reasoning, (b) prospect theory which explains framing and valuation and (c) theory of mind whi...

This article presents an overview of literature on behavioural and experimental asset pricing theory. We systematically review the evolution and current development of behavioural asset pricing models as an alternate approach to asset pricing in financial economics literature. A review and synthesis of research carried out in behavioural finance spreading across theoretical, empirical and experimental approaches are presented to understand the behavioural dimension of pricing of financial assets...

Abstract This study aims to examine the benefits of combining realized volatility, higher power variation volatility and nearest neighbour truncation volatility in the forecasts of financial stock market of DAX. A structural break heavy-tailed heterogeneous autoregressive model under the heterogeneous market hypothesis specification is employed to capture the stylized facts of high-frequency empirical data. Using selected averaging forecast methods, the forecast weights are assigned based on the...

Abstract De Bondt and Thaler (Int J Fore 9(3):355–371, 1995) point out that while von Neumann-Morgenstern (1947) utility functions, the axioms of cardinal utility (Copeland and Weston 1988), risk aversion, rational expectations, etc., have formed the basis for theories of choice under uncertainty, research in behavioral science, has either challenged these foundations or outright rejected them. Requiring investors to be utility maximizers, and using an approach similar to Scott-Horvath (J Financ...

In recent decades, pension fund investment has increased rapidly because of population aging and growing doubts about the viability of western public pension systems. As a result, pension funds have become dominant in stock markets. This paper examines the influence of the pension fund assets invested in equities on stock market development and the market efficiency of 13 European countries, from 1999 to 2014. Our results vary by country, by pension model and among the one-model countries. Never...

AbstractA novel interval optimisation approach is developed to include imprecise forecasts into the portfolio selection process for investors measuring upside potential and downside risk as deviations from a target return. Crisp scenarios are substituted by interval scenarios and the resulting interval optimisation problem is solved in a tractable manner by means of a bi-objective formulation exploiting a partial order relation between intervals. Four utility case studies involving assets from t...