Investor Behavior and Portfolio Optimization: Implications from Stochastic Dominance and Prospect theory

Abstract

This thesis investigates investor behavior and portfolio optimization, navigating through the theoretical framework of Stochastic Dominance (SD) and Prospect Theory. These two concepts serve as a bridge between traditional financial theories and the complexities of behavioral finance. The thesis extensively explores the connection between Central Moments and different SD concepts in Chapter 2, including an in-depth analysis of diversification. An empirical analysis of the Eastern Halloween effect, through the lens of SD, is undertaken in Chapter 3. This study reveals intriguing aspects of market efficiency and risk implications associated with the observed phenomenon. Chapter 4 revisits portfolio optimization, establishing links between Partial Moments, MV Analysis, and Prospect Theory. It introduces Prospect Stochastic Dominance (PSD) and its impacts on Mean-Variance Analysis and portfolio optimization. Chapter 5 extends the discussion to loss aversion, a critical component of Prospect Theory, and its implications on moments and Portfolio Choice. By integrating classic finance theories and behavioral finance, this thesis aspires to enrich the academic discourse and practical understanding of finance. The ultimate goal is to generate valuable insights that could enhance investment decision-making processes, contribute to better financial outcomes, and add nuance to our understanding of finance.