A behavioural approach to financial portfolio selection problem: an empirical study using heuristics

This thesis was submitted for the degree of Doctor of Philosophy and awarded by Brunel UniversityThe behaviourally based portfolio selection problem with investor's loss aversion and risk aversion biases in portfolio choice under uncertainty are studied. The main results of this work are developed heuristic approaches for the prospect theory and cumulative prospect theory models proposed by Kahneman and Tversky in 1979 and 1992 as well as an empirical comparative analysis of these models and the traditional mean variance and index tracking models. The crucial assumption is that behavioural features of the (cumulative) prospect theory model provide better downside protection than traditional approaches to the portfolio selection problem. In this research the large scale computational results for the (cumulative) prospect theory model have been obtained. Previously, as far as we aware, only small laboratory (2-3 arti cial assets) tests has been presented in the literature. In order to investigate empirically the performance of the behaviourally based models, a differential evolution algorithm and a genetic algorithm which are capable to deal with large universe of assets have been developed. The speci c breeding and mutation as well as normalisation have been implemented in the algorithms. A tabulated comparative analysis of the algorithms' parameter choice is presented. The performance of the studied models have been tested out-of-sample in different conditions using the bootstrap method as well as simulation of the distribution of a growing market and simulation of the t-distribution with fat tails which characterises the dynamics of a decreasing or crisis market. A cardinality and CVaR constraints have been implemented to the basic mean variance and prospect theory models. The comparative analysis of the empirical results has been made using several criteria such as CPU time, ratio between mean portfolio return and standart deviation, mean portfolio return, standard deviation , VaR and CVaR as alternative measures of risk. The strong in uence of the reference point, loss aversion and risk aversion on the prospect theory model's results have been found. The prospect theory model with the reference point being the index is compared to the index tracking model. The portfolio diversi cation bene t has been found. However, the aggressive behaviour in terms of returns of the prospect theory model with the reference point being the index leads to worse performance of this model in a bearish market compared to the index tracking model. The tabulated comparative analysis of the performance of all studied models is provided in this research for in-sample and out-of-sample tests

Multiple-interaction kinetic modelling of a virtual-item gambling economy

In recent years, there has been a proliferation of online gambling sites, which made gambling more accessible with a consequent rise in related problems, such as addiction. Hence, the analysis of the gambling behaviour at both the individual and the aggregate levels has become the object of several investigations. In this paper, resorting to classical methods of the kinetic theory, we describe the behaviour of a multi-agent system of gamblers participating in lottery-type games on a virtual-item gambling market. The comparison with previous, often empirical, results highlights the ability of the kinetic approach to explain how the simple microscopic rules of a gambling-type game produce complex collective trends, which might be difficult to interpret precisely by looking only at the available data

Mean Field Limit of a Behavioral Financial Market Model

In the past decade there has been a growing interest in agent-based econophysical financial market models. The goal of these models is to gain further insights into stylized facts of financial data. We derive the mean field limit of the econophysical model by Cross, Grinfeld, Lamba and Seaman (Physica A, 354) and show that the kinetic limit is a good approximation of the original model. Our kinetic model is able to replicate some of the most prominent stylized facts, namely fat-tails of asset returns, uncorrelated stock price returns and volatility clustering. Interestingly, psychological misperceptions of investors can be accounted to be the origin of the appearance of stylized facts. The mesoscopic model allows us to study the model analytically. We derive steady state solutions and entropy bounds of the deterministic skeleton. These first analytical results already guide us to explanations for the complex dynamics of the model

Exploring Higher-Order Risk Effects

Higher-order risk effects play an important role in examining economic behavior under uncertainty. A precautionary demand for saving has been linked to the property of prudence and the property of temperance has been used to show how the presence of an unavoidable risk affects one’s behavior towards a second risk. These two properties also play key roles in aversion to negative skewness and to kurtosis, respectively. Both properties recently have been characterized by preferences over lottery pairs in simple 50-50 gambles. The simplicity of this characterization is ideal for experimental investigation. This paper reports the results of such experiments and concludes that there is behavioral evidence for prudence, but not for temperance. Implications of these results for both expected-utility and non-expected-utility models are examined.risk, prudence, temperance, laboratory experiments

An Analysis of the Dismal Theorem

In a series of papers, Martin Weitzman has proposed a Dismal Theorem. The general idea is that, under limited conditions concerning the structure of uncertainty and preferences, society has an indefinitely large expected loss from high-consequence, low-probability events. Under such conditions, standard economic analysis cannot be applied. The present study is intended to put the Dismal Theorem in context and examine the range of its applicability, with an application to catastrophic climate change. I conclude that Weitzman makes an important point about selection of distributions in the analysis of decision-making under uncertainty. However, the conditions necessary for the Dismal Theorem to hold are limited and do not apply to a wide range of potential uncertain scenarios.Dismal theorem, Uncertainty, Climate change, Catastrophes