Portfolio Optimization Based on Prospect Theory

Celma Ribeiro, Alan Teixeira dos Santos

2025

Abstract

This paper investigates the application of prospect theory in the context of portfolio optimization and presents a model based on the mean absolute deviation and on Prospect Theory. By analyzing historical returns from assets of three critical sectors traded on B3 (Brazilian Stock Exchange) and over an eight-year period, a prospect optimization approach was implemented and its results were compared to those obtained from the Conditional Value at Risk (CVaR) approach. An additional application was held regarding one of the most relevant sector of assets in terms of contribution to the S&P500’s composition with the purpose to test the new model under different market conditions. Such results revealed the effectiveness of prospect theory in optimizing portfolios since those results were considered similar to the CVaR’s, but at higher returns. Both models were compared through different portfolio performance metrics and, notably, the prospect model exhibited competitive results in most cases. However, the study also identified opportunities for further refinements. Overall conclusions herein suggests the promise of prospect theory in addressing the needs of decision makers in portfolio management, delivering a singular approach that balances the possibility of gains and losses under different scenarios.

Paper Citation

in Harvard Style

Ribeiro C. and Santos A. (2025). Portfolio Optimization Based on Prospect Theory. In Proceedings of the 7th International Conference on Finance, Economics, Management and IT Business - Volume 1: FEMIB; ISBN 978-989-758-748-1, SciTePress, pages 51-60. DOI: 10.5220/0013331900003956

in Bibtex Style

@conference{femib25,
author={Celma Ribeiro and Alan Santos},
title={Portfolio Optimization Based on Prospect Theory},
booktitle={Proceedings of the 7th International Conference on Finance, Economics, Management and IT Business - Volume 1: FEMIB},
year={2025},
pages={51-60},
publisher={SciTePress},
organization={INSTICC},
doi={10.5220/0013331900003956},
isbn={978-989-758-748-1},
}

in EndNote Style

TY - CONF

JO - Proceedings of the 7th International Conference on Finance, Economics, Management and IT Business - Volume 1: FEMIB
TI - Portfolio Optimization Based on Prospect Theory
SN - 978-989-758-748-1
AU - Ribeiro C.
AU - Santos A.
PY - 2025
SP - 51
EP - 60
DO - 10.5220/0013331900003956
PB - SciTePress