Two Paradigms and Nobel Prizes in Economics: A Contradiction or Coexistence?

Abstract

Markowitz and Sharpe won the Nobel Prize in Economics more than a decade ago for thendevelopment of Mean-Variance analysis and the Capital Asset Pricing Model (CAPM). In the yearn2002, Kahneman won the Nobel Prize in Economics for the development of Prospect Theory. Cannthese two apparently contradictory paradigms coexist?nIn deriving the CAPM, Sharpe, Lintner and Mossin assume expected utility (EU)nmaximization following the approach proposed by Markowitz, normal distributions and risknaversion. Kahneman & Tversky suggest Prospect Theory (PT) and Cumulative Prospect Theoryn(CPT) as an alternative paradigm to EU theory. They show that investors distort probabilities,nmake decisions based on change of wealth, exhibit loss aversion and maximize the expectation ofnan S-shaped value function which contains a risk-seeking segment. Employing change of wealthnrather than total wealth contradicts EU theory. The subjective distortion of probabilities violatesnthe CAPM assumptions of normality and homogeneous expectations, and the S-shaped valuenfunction violates the risk aversion assumption. We prove in this paper that although CPT (and PT)nis in conflict to EUT, and violates some of the CAPM's underlying assumptions, the securitynmarket line theorem (SMLT) of the CAPM is intact in the CPT framework.