Prospect theory and mean-variance analysis: Does it make a difference in wealth management?

Abstract

We show that prospect theory is a valuable paradigm for wealth management. It describes well how investors perceive risk and with appropriate modeling it can be made consistent with rational decision making. Moreover, it can be represented in a simple reward-risk diagram so that the main ideas are easily communicated to clients. Finally, we show on data from a large set of private clients that there are considerable monetary gains from introducing prospect theory instead of mean-variance analysis into the client advisory process.