Journal of Behavioral Finance

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Value Functions for Prospect Theory Investors: An

Empirical Evaluation for U.S. Style Portfolios

Evanthia K. Zervoudi

To cite this article: Evanthia K. Zervoudi (2017): Value Functions for Prospect Theory
Investors: An Empirical Evaluation for U.S. Style Portfolios, Journal of Behavioral Finance, DOI:
10.1080/15427560.2018.1405005

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Published online: 13 Dec 2017.

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 JOURNAL OF BEHAVIORAL FINANCE
https://doi.org/10.1080/15427560.2018.1405005

Value Functions for Prospect Theory Investors: An Empirical Evaluation for U.S.
Style Portfolios
Evanthia K. Zervoudi
Athens University of Economics & Business

ABSTRACT KEYWORDS
The main aim of this article is to provide a general behavioral analysis that proposes a series of Prospect theory; Probability
different value functions for prospect theory (PT) investors incorporated into behavioral reward-risk distortion; S-shaped value
models that are finally solved so as to provide some specific optimal solutions. To do this, general function; Loss aversion;
behavioral reward-risk models, which contain all the basic elements of the PT, are first set up. Two Behavioral portfolio
optimization; Upper partial
reward and risk measures, the upper partial moment and the lower partial moment, are
Downloaded by [University of New England] at 22:16 04 January 2018

moment; Lower partial

subsequently used to create the various value functions. The technical difficulties arising during the moment
behavioral maximization process are overpassed by adapting the Rubinstein [1982] algorithm. The
results show that agents differentiate their behavior according to their type of preferences (S-
shaped, reverse S-shaped, kinked convex, and kinked concave value function) but they seem to
always prefer small capitalization and high positively skewed value stock portfolios. Probability
distortion also affects the optimal solutions of the problem, independently of the employing
weighting functional form; when subjective probabilities are employed the optimal weights of the
most risky positively skewed assets seem to increase. Probability distortion has an additional
important effect on optimal perspective values of the problem driving to a significant increase.

Introduction
For several years, expected utility theory (EUT) has been
one of the most popular methods in decision-making
analysis. EUT models represent rational and totally risk-
averse investors whose preferences are better described
by an increasing and totally concave utility functions.
Uncertainties are expressed in terms of probabilities
(objective and common for all agents) and outcomes in
terms of utilities. Many studies, however, demonstrate
that several deviations from the EUT framework, such as
probability transformation, loss aversion, scale compati-
bility, and the prominence effect, take place in practice.
In 1979, Kahneman and Tversky observed that preferen-
ces differ from investor to investor: some agents tend to
be risk averse, others risk seeking, and others are neither
totally risk averse nor totally risk seeking and not even
consistent with their decision making, although they all
behave rationally in the sense that they prefer more than
less. Based on this observation, they develop the most
popular alternative to EUT, prospect theory (PT), where
investors tend to be risk averse for returns considered as
gains and risk seeking for returns considered as losses.
Gains and losses are determined by a reference point
depending on the loss aversion of the agent. The most
representative preference function for this type of invest-
ors is an S-shaped value function (e.g., a function con-
cave for gains and convex for losses). The importance of
the aforementioned elements of PT in the economic
decision making process has been discussed in several
studies among which Barberis [2013] and Bleichrodt,
Pinto, and Wakker [2001].
The main aim of this article is to empirically evaluate
and compare behavioral reward-risk models that contain
all the basic elements of PT such as S-shaped value func-
tion, loss aversion, and probability distortion. I employ 2
reward and risk measures, the upper partial moment
(UPM) and the lower partial moment (LPM) to create
multiple value functions and the corresponding behavioral
reward-risk models. Their goal is to determine the optimal
asset allocations and the resulting optimal perspective val-
ues (the values resulting by the value function under con-
sideration if the optimal asset allocations are used as
weights) for each of these models. The optimization pro-
cess in a model with nonconcave (and nonconvex) value
function, which also has a kinked point at the reference
point, differs from the classical optimization method with

CONTACT Evanthia K. Zervoudi zervoudiev@aueb.gr Department of International and European Economic Studies, Athens University of Economics &
Business, Patission 76, Athens, Attica 104 34, Greece.
Color versions of one or more of the figures in the article can be found online at www.tandfonline.com/hbhf.
© 2017 The Institute of Behavioral Finance
 2 E. K. ZERVOUDI
a strictly concave utility function. So, I first create an algo-
rithm so as to overpass the difficulties of maximizing a
nonconcave and nondifferentiable (at the reference point)
function. A series of studies, such that of Levy and Levy
[2004], De Giorgi and Hens [2009], and Best and Grauer
[2016], also provide some specific optimal solutions
resulting from behavioral reward-risk models developed
in a PT framework. The main aim of these articles is to
make a comparison between the PT and the mean-vari-
ance analysis. Other studies that empirically evaluated PT
models are that of De Giorgi, Hens, and Mayer [2007]
and Hens and Vlcek [2011], who examined if the disposi-
tion effect could be explained by the PT; Pirvu and
Schulze [2012] made a multistock portfolio selection anal-
ysis under PT (for stocks that follow multivariate elliptical
distributions). The purposes of the present article differ
Downloaded by [University of New England] at 22:16 04 January 2018
significantly by those papers’ goals.
More specifically, I present original evidence and
contributes to the relevant literature in several ways.
First, I provide a general behavioral portfolio optimiza-
tion model for investors with arbitrary preferences and
various risk attitudes taking into account higher
moments, such as skewness and kurtosis, which are sig-
nificant elements in real market analysis. The first main
component of the model is the value function; to create
the value function, I combine the upper partial moment
(as reward measure) and the lower partial moment (as
risk measure). The article that first introduced the LPM
as a risk measure in financial models is that of Bawa
and Lindenberger [1977]. Specifically, Bawa and Lin-
denberger developed a capital asset pricing model
(CAPM) into a mean-LPM framework and they showed
that when the probability and the portfolio returns dis-
tributions are normal, stable, or Student t then the
mean-lower partial moment CAPM is reduced to the
traditional mean-scale CAPM. After this article, various
studies employed these reward-risk measures to
develop UPM/LPM analyses (see Fishburn [1977], Sor-
tino, Van der Meer, and Plantinga [1999], Moreno,
Nawrocki, and Olmeda [2006]). Fishburn [1977] pro-
posed the LPM model so as to explain the risk-seeking
behavior above and the risk-averse behavior below the
reference return; Sortino et al. [1999] proposed as per-
formance measure the UPM/LPM ratio to capture more
realistic investment behaviors while Cumova and
Nawrocki [2014] developed a general UPM/LPM port-
folio optimization model (see also Moreno, Nawrocki,
and Olmeda [2006]). Most of these articles follow clas-
sical optimization methods where the LPM is mini-
mized under the constraint the UPM to remain above a
target return level or the UPM is maximized under the
constraint the LPM to remain below a target return
level, as Markowitz [1952a] did in his mean-variance
model. I extend this line of research by incorporating
loss aversion and probability distortion so as to create a
general behavioral model that includes all the basic
components of the PT. At the same time I solve this
problem to provide specific optimal solutions, by fol-
lowing behavioral optimization methods and maximiz-
ing the whole value function under the appropriate
constraints. This is quite important because by maxi-
mizing the whole value function (without separating
the analysis into maximization of the UPM or minimi-
zation of the LPM (i.e., I do not differentiate their anal-
ysis for outcomes below and above the reference point)
I take under consideration mixed bets with both posi-
tive and negative returns which are quite common in
finance. However, the maximization of a function that
is non–quasi-concave and nonsmooth creates a series
of problems in optimization process that are overpassed
employing the Rubinstein [1982] algorithm.
Second, I set under examination 5 different value
functional forms among which 2 of the most widely
used functions. More specifically, I examine the S-
shaped value function proposed by Kahneman and
Tversky [1979], 2 types of the reverse S-shaped value
function proposed by Markowitz [1952b], the kinked
concave, and the kinked convex value functions. Here it
is important to underline that the value function cap-
tures the risk and the potential attitude of an investor
and shows how this may change according to the out-
come of the problem. Employing these 5 value func-
tional forms, I examine how the optimal allocations are
differentiated according to the agents’ reward and risk
attitudes. As the value functions under consideration are
not always totally concave (or quasi-concave), the first-
order conditions are necessary but not sufficient which
means that they can only describe local optima (i.e.,
such a problem may not have a global maximum but
only local maxima). After that, in each of these value
functions I have incorporated loss aversion that captures
the psychological phenomenon according to which
investors are more sensitive to losses than to gains. The
using loss aversion index is that of Kahneman and Tver-
sky [1979], which is equal to 2.25 (the pain from losses is
more than double than the pleasure from gains). The
incorporated loss aversion index makes the value func-
tions steeper for losses than for gains, a fact that creates
an additional difficulty in maximization process.
Third, I take the analysis one step further by using 2
weighting schemes for the outcomes of the problem; I
use both linear and nonlinear weighting schemes to
investigate whether the introduction of probability dis-
tortion in the model may affect the empirical results.
During the years it has been observed that people do not
weight outcomes linearly but they tend to underestimate

large and moderate probabilities and overestimate small
probabilities. The probability distortion captures this
underweighting of large and overweighting of small
objective probabilities, through a nonlinear, continuous,
and strictly increasing probability weighting function. In
the case of probability distortion each outcome is
weighted by a decision weight that is subjective for each
agent and arises from her personal information. There
are various studies where probability distortion and S-
shaped, concave, and convex value functions are com-
bined into one model (see among others Tversky and
Kahneman [1992], Wu and Gonzalez [1996, 1999], Pre-
lec [1998], Hens and Vlcek [2011], Best and Grauer
[2016]). The role of the probability distortion in the pres-
ent article is to examine if the optimal solutions of the
maximization problem are differentiated using subjective
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and objective probabilities. To ensure that their results
are not due to a specific probability weighting functional
form, I use 2 weighting functions: (1) Tversky and Kah-
neman [1992] and (2) Prelec [1998].
Their results indicate that the value functional form
does influence the outcome. Each value function repre-
sents a specific investment strategy; investors who follow
a conservative strategy assign higher weights to less risky
assets and invest smaller percentages of their wealth to
very risky assets. These investors have smaller optimal
perspective values relatively to investors who follow
aggressive strategies. The most conservative strategy is
that of agents whose preferences are described by a
kinked concave value function while the most aggressive
and the most profitable strategy is that of agents with a
kinked convex value function. This result confirms the
expectations, as agents with by a kinked concave value
function are totally risk averse while agents with a kinked
convex value function are characterized by (total) risk
seeking. Agents with S-shaped and reverse S-shaped
value functions also differentiate the allocation of their
wealth according to their risk and potential attitudes
with potential seekers to follow more aggressive strate-
gies than potential averse agents.
Probability distortion also influences empirical results,
although the specific weighting functional form does not
play an important role. Optimal asset allocations are
affected by probability distortion as follows: positively
skewed assets become more attractive to investors when
I assume probability distortion; their weights are
increased remarkably relatively to the other assets, for all
value functions. However, the allocations are mostly
related to the strategy that an investor follows (deter-
mined by her preferences) and less by the probabilities.
The effect of probability distortion is much clearer on
optimal perspective values in the sense that perspective
values increase significantly when probability distortion
JOURNAL OF BEHAVIORAL FINANCE 3
is introduced in the model especially for agents who fol-
low more aggressive strategies. The rest of the article is
organized as follows: the second section discusses the
methodology, the third section contains data and empiri-
cal results, and the fourth section concludes the article.
Methodology
UPM/LPM
The classical reward-risk model is composed by a reward
measure m and a risk measure r; the tradeoff between
reward and risk is given by the utility function, which is
increasing in the reward measure and decreasing in the
risk measure. I employ as a reward measure the UPM
measure and as risk measure the LPM measure. The
UPM measure gives the positive deviations of returns
from a target return. In the model the reference point is
the risk-free rate. This reference return represents a min-
imum target return that an investor requires so as to
cover her liabilities. These positive deviations in the new
model are not minimized anymore as in the mean-vari-
ance model. Mathematically the UPM is formulated as:
X
T
UPM D pt
½maxð0; rt ¡ rpÞa (1)
tD1
In Equation 1, rt are the assets’ returns, a is the degree
of the UPM and rp is the reference point of the model
(risk-free rate). The parameter a has to do with the
investors’ potential attitude. Specifically:
 a D 1 implies potential neutrality which means that
an investor is indifferent to an increase or a decrease
of the reward.
 a < 1 implies potential aversion which means that
the higher the returns above the reference return,
the smaller the satisfaction of an investor.
 a > 1 implies potential seeking, which means that
the higher the returns above the reference return,
the greater the satisfaction of an investor.
The LPM captures only downside deviations from a
benchmark return. Mathematically, the LPM is formu-
lated as following:
X
T
LPM D pt
½maxð0; rp ¡ rt Þb (2)
tD1
In Equation 2, rt are the assets’ returns, b is the degree
of the LPM, and rp is the reference point of the model.
The parameter b has to do with investors’ risk attitude.
Specifically:
 4 E. K. ZERVOUDI
 b D 1 implies risk neutrality which means that an
investor is indifferent to an increase or a decrease of
the risk.
 b < 1 implies risk seeking (e.g., risk-loving invest-
ors), which means that the more the returns fall
below the target return, the more investors prefer
them.
 b > 1 implies risk aversion (e.g., risk-averse invest-
ors), which means that the more the returns fall
below the target return, the more investors dislike
them.
Value functions
The utility function of the classical reward-risk model
can be represented as:
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X
T consider protection against losses more important
U ðxÞ D ½½maxð0; rt ¡ rpÞa C ½maxð0; rp ¡ rt Þb  (3)
tD1
PT preferences can be represented as:
X
T   and an S-shaped value function (concave for gains
Vðrt Þ D w.pt /
½½max 0; rt ¡ rp a
tD1
 
¡ L
½max 0; rp ¡ rt b  (4)
In Equation 4, w.pt / are the decision weights that
correspond to returns rt 8 t D 1; 2; ::; T (I shall use 2
different probability weighting functions), L is the loss
aversion index that takes the value of 2.25 (see Kahne-
man and Tversky [1979], He and Zhou [2011], among
others), implying that losses are more than twice painful
for investors than the pleasure of similar gains. I use the
same loss aversion parameter (for all value functional
forms) so as to make a direct comparison among the
optimal allocations of agents who are “equally” loss
averse (have the same loss aversion degree) but they
have different preferences (i.e., see how the optimal solu-
tions are differentiated according to the value functional
form under consideration). The evaluation of assets is
done by investors according to gains .rt > rp ) and losses
.rt < rp ). The first part of the value function represents
the positive deviations of assets returns from the refer-
ence point (gains), that is, the reward measure m,
whereas the second part represents the negative devia-
tions of assets’ returns from the reference point (losses),
that is, the risk measure r. Having found the optimal
asset allocations, I replace these (optimal) allocations to
the value function under consideration to find the opti-
mal perspective values.
Regarding the value functions, different combinations
of the parameters may lead to several value functional
forms such as the reverse S-shaped value functions of
Friedman and Savage [1948] and Markowitz [1952b]
and the S-shaped value function of PT proposed by Kah-
neman and Tversky [1979]. An important issue is
whether the functional form chosen for the analysis
affects the empirical results. To investigate this issue in
more detail I employ a number of different value func-
tional forms and the corresponding strategies as follows:
 a; b > 1: High (above unity) parameter values
imply potential seeking and risk aversion and a
reverse S-shaped value function (concave for losses
and convex for gains). I try both the cases where
a D b D 1.8 and the case where a D 1.8 and b D
3.6 (the case where the risk parameter b is higher
than the potential parameter a (i.e., when investors
than their exposure to gains). Note that these
parameters are close the ones in Cumova and
Nawrocki [2014] (i.e., a D 2 and b D 4).
 0 < a; b < 1: Parameter values between 0 and
unity suggest potential aversion and risk seeking
and convex for losses). This value function is the
classical PT value function. I use the estimations of
Kahneman and Tversky (i.e., a D b D 0.88).
 a > 1 and 0 < b < 1: These values imply both
potential and risk seeking and suggest a value function
that is in general a kinked convex (because of the
kinked point at the reference point) value function for
both losses and gains. I use as parameters a D 1.8 and
b D 0.88.
 0 < a < 1 and b > 1: These values imply poten-
tial aversion and risk aversion and suggest a kinked
concave value function for both losses and gains
resembling the classical concave function of the
EUT. I use as parameters a D 0.8 and b D 1.88.
To weight outcomes 3 approaches are employed: the
classical linear probability weighting (objective probabili-
ties) and 2 approaches with probability distortion (Kah-
neman and Tversky [1992] Prelec [1998]) in which
decision weights (w(p)) subjective for each agent (arising
from her personal information) are used. The 2 last
approaches are employed to take into account the proba-
bility transformation that is a common violation of the
EUT, but also ensure that the results are not due to a spe-
cific probability weighting functional form. The experi-
mental outcomes are considered as equally likely. As the
analysis is developed into a PT framework, the transfor-
mation is applied directly on the individual objective
probabilities of the outcomes and not on the cumulative
ones as in the CPT framework. Thus, the subjective

probabilities that weight the experimental outcomes will
be equal and they will be calculated via the subsequent
probability distortion functions by applying the transfor-
mation directly on the individual objective probabilities.
The transformation function w() is a nondecreasing
function w : ½0; 1 ! ½0; 1 with wðpÞ > p for small proba-
bilities and wðpÞ < p for large probabilities while wðpÞ D p
for p D 0 and p D 1. More specifically, I first use the
reverse S-shaped probability distortion function proposed
by Tversky and Kahneman [1992], that is:
pg
wðpÞ D (5)
.pg C ð1 ¡ pÞg /16 g
In Equation 5, the parameter g  0.65 determines the
overweighting of small probabilities and the underweight-
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ing of large probabilities. This functional form gives the
subjective probabilities that agents give to each event and
it is in accordance with the observation that investors
tend to overweight small objective probabilities and
underweight moderate and large objective probabilities.
Second, I use the reverse S-shaped probability weight-
ing function proposed by Prelec [1998], where:
wðpÞ D expð ¡ bð ¡ lnpÞÞ~a (6)
Such a transformation deflates the large probabilities
and inflates the small probabilities. The parameter a ~ maxima. Another difficulty is that the loss aversion index,
determines the overweighting of small probabilities and
the underweighting of large probabilities. Prelec’s proba-
bility weighting function is a well-behaved probability
distortion function, which is regressive, asymmetric,
reflective, and reverse S-shaped (concave for the initial
interval of small probabilities and convex for the proba-
bility interval of large probabilities). As the risk aversion
parameter a ~ decreases the function becomes more
regressive, more subproportional and more (reverse) S-
shaped while for a ~ D 1 the weighting function is the
identity one w.p/ D p. Moreover, Prelec’s weighting
function is a 1-parameter subproportional functional
form with a fixed and an inflection point at p D 16 e D
0:37 (asymmetric function). The fact that the fixed point
is below the probability 0.5 drives to a decrease of an
uncertain outcome’s weight relatively to the certain out-
comes’ weights and thus makes investors more risk
averse for gains and more risk seeking for losses, because
of the reflection. I set b D 1 and a ~ D 0.74, the aggregate
least-squares estimations by Wu and Gonzalez [1996].
To formulate the asset allocation problem I consider as
λ the vector of the assets’ weights. In this model I assume
N assets in the investor’s portfolio with λi i D 1 ,.., N the
weight of each asset. The constraints that I impose in the
model are the budget constraint, that an agent can
JOURNAL OF BEHAVIORAL FINANCE 5
purchase assets whose prices
PNare less or equal to his wealth
to maximize his welfare i D 1 λi D 1/, and the short-sell-
ing constraint, that the weights of portfolios assets must be
nonnegative (λi  0 8i). In this way, I avoid the case of
infinite leverage and a great risk exposure.
Hence, the asset allocation model is formulated as fol-
lows:
"" ! !#a
X
T X
N
max w.pt /
max 0; rit
λi ¡ rp
λ
tD1 iD1
" !!#b #
X
N
¡ L max 0; rp ¡ rit
λi
iD1
X
N
s:t: λi D 1
iD1
λi  0 8i (7)
P
In Equation 7, NiD 1 rit
λi D rtT
λ is the portfolio
return at each t D 1…T, rt is the vector of the assets’
returns at each t D 1…T, and λ the vector of the assets’
weights. There are several difficulties in maximization pro-
cess of a behavioral reward-risk model. First, as the value
function is not quasi-concave (and of course not totally
concave) the first-order condition may only describe local
which is incorporated in the value function, makes the
objective function nonsmooth and results a nondifferenti-
ability at the reference point. In the case of a piecewise lin-
ear value function this problem can easily be dealt with by
using linear programming. Specifically, a nonlinear pro-
gramming problem with a piecewise linear concave func-
tion maximizing under linear constraints can be easily
reformulated to a linear programming problem using aux-
iliary variables instead of the deviations from the reference
point. In the general case of changing risk aversion, which
is the case of the value functions that I examine in this arti-
cle, several computational issues arise. For example, the
value function is nonsmooth but it has a kinked point at
the reference point where the value function is nondiffer-
entiable; here I use smoothing techniques to get around
the reference point. Also, the value function is non–quasi-
concave, which implies that there are upper sets that are
nonconvex sets and consequently, the portfolio optimiza-
tion problem may have several local maxima but not a
global solution.
I follow a process similar to De Giorgi et al. [2006],
introducing probability distortion, specific risk and
reward measures, and different value functional forms.
First, the nonsmoothness of the value function is treated
using cubic spines. Specifically, to deal with the
 6 E. K. ZERVOUDI
nondifferentiability problem, I replace the nonsmooth
value function V(x) by the smooth V~ ðxÞ:
~ ðxÞ
V et al. [2007]).

a0 x3 C a1 x2 C a2 x C a3 ; if x 2 ½rp ¡ d; rp C d
D Data and empirical results
V ðx Þ ; elsewhere
In Equation 8, d D 10¡6. The goal of this method is to
replace the nonsmooth part of the value function by a
smooth and thus differentiable cubic polynomial. I take a
too small random number d to be as close as possible to
the reference point and I approach the nonsmooth part
of the value function using cubic splines to make it
smooth. So, around the reference point the value func-
Downloaded by [University of New England] at 22:16 04 January 2018
tion is replaced by a cubic polynomial, which is now dif-
ferentiable. The rest of the value function remains the
same, as away from the reference point the value func-
tion is smooth and differentiable and thus there is not
problem in maximization process.
Thus, the asset allocation model is now formulated as:
!!
X
T X
N
max ~
w.pt /
V rit
λi
λ growth stocks, indicating that higher returns may be a
tD1 iD1
X
N is considered as a measure of risk for financial assets).
s:t: λi D 1
iD1
λi  0 8i
The second problem is that the value function is non–
quasi-concave, which implies that the portfolio optimiza-
tion problem may have several local maxima but not a
global solution. To overpass this problem I consider N
starting points that have been randomly generated on the
P In other words, if positively skewed stocks offer them
unit simplex {λ j N i D 1 λ i D 1, λ i 0 8i}, according to the
uniform distribution over the unit simplex. I employ the
algorithm of Rubinstein [1982] to find the optimal alloca-
tion in their problem. Briefly, this algorithm starts with the
generation of n pseudorandom numbers (xi 8 i D 1 … n)
according to the uniform distribution on [0, 1], continues
with their transformation to yi D ¡log (xi) 8 i D 1 … n,
corresponding to the exponential distribution with parame-
ter 1, and terminates with their normalization as
following Pyni corresponding to the uniform distribu-
y
iD1 i
tion over the unit simplex. This process is repeated n times.
Thus, starting from n starting points I get n locally optimal
allocations for each of the value functions which are used
to find the corresponding optimal perspective values (at
each of these optimal allocations). The allocation with the
highest perspective value is considered as the solution of
the problem. The choice of the n starting points is crucial
for the quality of the solution. I repeat this process by
increasing n until the solution is unchanged (see De Giorgi
(8) For the empirical analysis I employ data on U.S. style
portfolios (stocks listed in on the NYSE, AMEX, and
NASDAQ). More specifically, the sample consists of 10
canonical decile portfolios formed on size (market equity
[ME]) and 10 decile portfolios formed on value (book to
market equity ratio [B/M]). All data are available from
Kenneth French’s online data library. I employ annual
real returns for the period 1927–2013 (87 years). Table 1
presents descriptive statistics of the sample portfolios.
There seems to be an reverse relation between firm size
and stock returns, that is, the smaller the market capitali-
zation of the firms included in a portfolio is, the larger
the portfolios’ return is. Also, for portfolios formed on
B/M ratio, the higher the B/M ratio is, the higher the
average return is (i.e., value stocks seems to outperform
growth stocks). Small and value stocks seem to have
higher variance/standard deviation than large and
compensation for the higher variance (which in general
Note, however, that small and value stocks also have
positive skewness while large and growth stocks are nega-
(9) tively skewed. This is a quite desirable feature of assets
especially in PT where investor have a clear preference for
positive-skewed assets. More specifically, if a stock has
positive skewness, investors believe that they have a
chance (even a very small one) of becoming very wealthy.
This belief is reinforced by the probability distortion in
PT where investors tend to overweight too small chances.
even a very small chance to have a great return from this
investment this chance is subjectively distorted and makes
this investment to be considered as a great opportunity.
After that, the maximum return that small and value
stocks may offer is in excess of 100% and too high rela-
tively to the maximum return of large and growth stocks.
This fact may enhance the belief of PT investors that the
positively skewed and more profitable small and value
stocks seems to be a better investment than the negatively
skewed and less profitable large and growth stocks.
Another article that also points out the preference of PT
investors to positively skewed stocks is that of Barberis
and Huang [2008]. Specifically, authors in their article
study asset pricing issues in a cumulative PT (CPT)
framework emphasizing the probability transformation
feature of CPT and the probability weighting function
 JOURNAL OF BEHAVIORAL FINANCE 7

Table 1. Descriptive statistics.

Mean Variance Standard Deviation Kurtosis Skewness Sharpe Ratio Min Max

Panel A: Portfolios formed on Market Capitalization

Small 0.1919 0.1551 0.3939 1.1246 0.7736 0.4871 ¡0.5437 1.4272
Dec 2 0.1711 0.1286 0.3586 3.1056 0.8874 0.4772 ¡0.5553 1.7165
Dec 3 0.1679 0.0992 0.3150 2.5915 0.6410 0.5329 ¡0.5420 1.4776
Dec 4 0.1592 0.0868 0.2946 0.7666 0.3699 0.5405 ¡0.4911 1.1476
Dec 5 0.1539 0.0759 0.2755 1.0778 0.2161 0.5585 ¡0.4788 1.1539
Dec 6 0.1537 0.0679 0.2606 0.6752 0.1021 0.5899 ¡0.4765 1.0141
Dec 7 0.1463 0.0653 0.2554 1.4656 0.1824 0.5727 ¡0.4451 1.0829
Dec 8 0.1369 0.0549 0.2344 1.4449 0.0507 0.5842 ¡0.4716 0.9793
Dec 9 0.1298 0.0471 0.2171 0.6579 ¡0.3904 0.5980 ¡0.5053 0.7136
Large 0.1117 0.0372 0.1929 ¡0.0896 ¡0.4499 0.5788 ¡0.4172 0.4861
Panel B: Portfolios formed on B/M Ratio
Growth 0.1102 0.0507 0.2252 ¡0.4265 ¡0.1836 0.4894 ¡0.4108 0.5829
Dec 2 0.1211 0.0393 0.1983 ¡0.2360 ¡0.2394 0.6106 ¡0.3606 0.5751
Dec 3 0.1186 0.0391 0.1978 0.09036 ¡0.2386 0.5994 ¡0.3886 0.634
Dec 4 0.1215 0.0494 0.2223 2.1081 0.1204 0.5466 ¡0.5239 0.9575
Dec 5 0.1320 0.0507 0.2251 1.9613 ¡0.0407 0.5867 ¡0.6142 0.9126
Dec 6 0.1327 0.0491 0.2215 1.7590 ¡0.1960 0.5988 ¡0.6160 0.7671
Dec 7 0.1343 0.0576 0.2400 1.7269 ¡0.1073 0.5596 ¡0.6318 0.9626
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Dec 8 0.1561 0.0705 0.2655 2.6297 0.4950 0.5881 ¡0.5448 1.2063

Dec 9 0.1641 0.0721 0.2686 2.5199 0.4397 0.6112 ¡0.5256 1.2408
Value 0.1751 0.1127 0.3358 1.9364 0.3705 0.5216 ¡0.5799 1.4991

Note. Annual return descriptive statistics on U.S. style portfolios (i.e., 10 canonical decile portfolios formed on size [market equity (ME)]) and 10 decile portfolios
formed on value (book to market equity ratio (B/M)]). All data are available from Kenneth French’s online data library. Sample period: 1927–2013 (87 years).

Figure 1. Various value functions.

 8 E. K. ZERVOUDI
effects; their main results that an asset’s own skewness
may be (over)priced and that the probability distortion
has a significant role in the decision-making process of
PT investors are in accordance to the results of the pres-
ent article, and especially to the ascertainment that PT
investors prefer positively skewed stocks such as small
and value stocks, a preference that is reinforced by the
probability distortion (as the too small gain probabilities
of these assets are overweighted).
Value functions
Regarding value functions, Figure 1 presents the different
functions that I obtain with their dataset for various coeffi-
cient assumptions. As can be seen from the figure, when
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both parameters are set to less than 1 (a D b D 0.88) the
resulting value function is S-shaped (i.e., strictly concave for
gains and strictly convex for losses). This type of functional
form represents agents who tend to be risk averse for out-
comes considered as gains and risk seeking for outcomes
considered as losses. When both parameters are set to be
greater than 1 (a D b D 1.8) the resulting value function is
reverse S-shaped (i.e., strictly convex for gains and strictly
concave for losses). Such a function represents investors
whose behavior is characterized by risk aversion for losses
and potential seeking for gains. In this case, it makes
sense to examine separately what happens when the risk
parameter b is higher than the potential parameter a
(a D 1:8 < b D 3:6/ because investor behavior is char-
acterized by risk aversion for losses (i.e., the protection
against losses [expressed by the parameter b]) is more
important than the exposure to gains (expressed by the
parameter a). When the potential parameter a is set to be
greater than unity and the risk parameter b smaller than
unity (a D 1.8 and b D 0.88) then the resulting value func-
tion is a kinked convex function for both losses and gains.
Such a function represents investors whose behavior is char-
acterized by risk seeking and potential seeking. This type of
investors is aggressive enough and is willing to undertake
great risks by investing to most risky assets that are related
to high average returns, to derive the greatest possible satis-
faction (potential seeking). When the potential parameter a
is smaller than 1 and the risk parameter b is greater than 1
(a D 0.88 and b D 1.8) then the resulting value function is a
kinked concave function for losses and for gains, which
resembles the classical concave value function of the expected
utility theory. Such a function represents a conservative
investor whose behavior is characterized by risk and poten-
tial aversion. This investor is unwilling to undertake great
risks since the satisfaction that she will derive by the addi-
tional potential won’t be adequate to compensate her great
risk exposure (potential aversion).
Optimal asset allocations
The following Table 2 presents results for the various
value functions when I assume no probability distortion,
for size portfolios (panel A) and B/M portfolios (panel
B). The optimal asset allocation for investors with an S-
shaped function is to invest roughly 35% in the smallest
capitalization portfolio (small portfolio) and roughly
53% in high value portfolios (16.42% in decile 8, 22.15%
in decile 9, and 15.51% in the value portfolio). For invest-
ors with a reverse S-shaped function the results indicate
an optimal asset allocation that weighs heavily toward
the smallest capitalization portfolio. For instance, when
the 2 parameters are equal (a D b D 1.8), agents give the
greatest weight to the small stocks’ portfolio (85.84%)
and the second larger weight to size decile 2 (9.41%).
When the 2 parameters are not equal (a D 1.8, b D 3.6),
agents again give the greatest weight to the small stocks’
portfolio (87.35%) and the second larger weight to size
decile 2 (10.41%). B/M portfolios do not seem to be
important in this case (e.g., the weight of the value port-
folio varies between 0.005% and 0.22%). For a kinked
convex value function the 2 smallest size decile portfolios
have a combined weight of roughly 54% (32.5% and
22.08%), while the value portfolio has a weight of
11.37%. For the kinked concave function the smallest
size portfolio has a weight of 36.76% while the 2 high B/
M value portfolios have a combined weight of around
43% (36.46% for value decile 9 and 6.46% for decile 10).
So, in the case where objective probabilities are employed
in the model, investors choose to invest the highest pro-
portion of their wealth to the riskiest and most profitable
positively skewed small stock portfolio for all types of
preferences (i.e., S-shaped, reverse S-shaped, kinked con-
vex, and kinked concave value functions). Agents who
are potential averse (S-shaped and kinked concave value
function) give smaller weights to this too risky asset
while potential seekers (reverse S-shaped and kinked
convex value function) who derive great satisfaction
from very high potential, they give higher weights since
this asset has the highest average return.
The following Table 3 presents results for the various
value functions when I assume probability distortion and
employ the Kahneman and Tversky [1979] weighting
function, for size portfolios (panel A) and B/M portfolios
(panel B). The optimal asset allocation for investors with
an S-shaped function and probability distortion is to
invest 37.49% in the smallest capitalization portfolio and
roughly 47% in value portfolios (34.96% in decile 9 and
12.22% in the value portfolio). For investors with a
reverse S-shaped function the results indicate, as previ-
ously, that optimal asset allocation weighs heavily toward
the smallest capitalization portfolio. For instance, when
 JOURNAL OF BEHAVIORAL FINANCE 9

Table 2. Optimal asset allocation: No probability distortion.

Value Function

S-shaped a D 0.88 Reverse S-shaped a D 1.8 Reverse S-shaped a D 1.8 Convex a D 1.8 Concave a D 0.88
b D 0.88 b D 1.8 b D 3.6 b D 0.88 b D 1.8

Panel A Style Portfolio: Market Capitalization

Small 0.3478 0.8584 0.8735 0.3250 0.3676
Dec 2 0.0078 0.0941 0.1041 0.2208 0.0003
Dec 3 0.0040 0.0170 0.0033 0.1871 0.0009
Dec 4 0.0172 0.0171 0.0020 0.0478 0.0037
Dec 5 0.0103 0.0030 0.0016 0.0064 0.0031
Dec 6 0.0098 0.0007 0.0012 0.0044 0.0033
Dec 7 0.0072 0.0009 0.0014 0.0006 0.0031
Dec 8 0.0035 0.0011 0.0011 0.0046 0.0032
Dec 9 0.0046 0.0008 0.0008 0.0020 0.0029
Large 0.0038 0.0004 0.0005 0.0018 0.0023
Panel B Style Portfolio: B/M Ratio
Growth 0.0023 0.0001 0.0005 0.0020 0.0016
Dec 2 0.0064 0.0005 0.0005 0.0027 0.0018
Dec 3 0.0067 0.0005 0.0007 0.0025 0.0020
Dec 4 0.0031 0.0006 0.0010 0.0035 0.0031
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Dec 5 0.0143 0.0007 0.0009 0.0102 0.0074

Dec 6 0.0088 0.0003 0.0006 0.0017 0.0080
Dec 7 0.0017 0.0003 0.0009 0.0019 0.0042
Dec 8 0.1642 0.0003 0.0015 0.0024 0.1523
Dec 9 0.2215 0.0029 0.0018 0.0588 0.3646
Value 0.1551 0.0005 0.0022 0.1137 0.0646
Optimal value 0.2252 0.1740 0.2040 0.2770 0.1590

Note. Optimal asset allocations for value functions without probability distortion and for various assumptions about the coefficients. The sample consists of U.S.
style portfolios (i.e., 10 canonical decile portfolios formed on size [market equity (ME)]) and 10 decile portfolios formed on value (book to market equity ratio [B/
M]). All data are available from Kenneth French’s online data library. Sample period: 1927–2013 (87 years).

the 2 parameters are equal (a D b D 1.8), agents give the are not equal. For a kinked convex value function the 2
greatest weight to the small stocks’ portfolio (88.25%) smallest size decile portfolios have a combined weight of
and the second larger weight to size decile 2 (10.48%); roughly 60% (39.85% and 21.56%), whereas the value
the same happens when I assume that the 2 parameters portfolio has a weight of 15.8%. For the kinked concave

Table 3. Optimal asset allocation: Kahneman and Tversky [1992] weighting function.
Value Function

S-shaped a D 0.88 Reverse S-shaped a D 1.8 Reverse S-shaped a D 1.8 Convex a D 1.8 Concave a D 0.88
b D 0.88 b D 1.8 b D 3.6 b D 0.88 b D 1.8

Panel A Style Portfolio: Market Capitalization

Small 0.3749 0.8825 0.8809 0.3985 0.3830
Dec 2 0.0012 0.1048 0.1058 0.2156 0.0000
Dec 3 0.0080 0.0004 0.0002 0.0018 0.0026
Dec 4 0.0069 0.0013 0.0021 0.1079 0.0015
Dec 5 0.0023 0.0010 0.0006 0.0036 0.0012
Dec 6 0.0013 0.0010 0.0006 0.0224 0.0016
Dec 7 0.0008 0.0009 0.0005 0.0035 0.0016
Dec 8 0.0104 0.0008 0.0004 0.0067 0.0020
Dec 9 0.0084 0.0004 0.0008 0.0059 0.0020
Large 0.0096 0.0004 0.0008 0.0028 0.0011
Panel B Style Portfolio: B/M Ratio
Growth 0.0086 0.0004 0.0004 0.0061 0.0007
Dec 2 0.0097 0.0004 0.0006 0.0054 0.0010
Dec 3 0.0075 0.0005 0.0007 0.0039 0.0019
Dec 4 0.0100 0.0006 0.0008 0.0030 0.0014
Dec 5 0.0174 0.0008 0.0006 0.0023 0.0062
Dec 6 0.0091 0.0001 0.0007 0.0013 0.0197
Dec 7 0.0031 0.0006 0.0006 0.0035 0.0022
Dec 8 0.0391 0.0008 0.0012 0.0174 0.1291
Dec 9 0.3496 0.0012 0.0012 0.0304 0.3919
Value 0.1222 0.0011 0.0006 0.1580 0.0493
Optimal Value 0.7023 0.5949 0.7100 0.8620 0.2233

Note. Optimal asset allocations for value functions with probability distortion (Kahneman and Tversky [1992]) and for various assumptions about the coefficients.
The sample consists of U.S. style portfolios (i.e., 10 canonical decile portfolios formed on size [market equity (ME)]) and 10 decile portfolios formed on value
(book to market equity ratio (B/M)]). All data are available from Kenneth French’s online data library. Sample period: 1927–2013 (87 years).
 10 E. K. ZERVOUDI

function the smallest size portfolio has a weight of 38.3%
whereas the 2 high B/M value portfolios have a com-
bined weight of around 44% (39.19% for value decile 9
and 4.93% for decile 10).
The results for the case in which I assume probability
distortion and employ the Prelec [1998] weighting func-
tion are presented in Table 4 and indicate that the choice
of the weighting function does not matter much for the
optimal asset allocation. In other words the results in
Table 4 are qualitatively similar to the results in Table 3.
For instance, the optimal asset allocation for investors
with an S-shaped function is to invest about 40%
(37.49% in Table 3) in the smallest capitalization portfo-
lio and roughly 45% (47% Table 3) in value portfolios;
for investors with an reverse S-shaped function the
results indicate that optimal asset allocation weighs
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kinked concave value functions) with potential averse
agents to give smaller weights to this too risky asset than
potential seekers.
Overall, the results in this subsection indicate that dif-
ferent value functions result to different optimal asset
allocations: all value functions suggest a higher weighting
for small capitalization firms compared with value firms;
particularly the reverse S-shaped functions suggest a sig-
nificantly higher weighting for small firms. Also, proba-
bility distortion seems to play a role in the sense that it
results an increase of extreme style portfolios’ weights
(small-cap and high B/M); however, the exact weighting
functional form does not play a substantial role. The
results indicate that PT investors believe that investing to
a positively skewed asset has a chance (a very small one)
to produce very high returns with high risk; thus they

heavily toward the smallest capitalization portfolio; for a
kinked convex value function the 2 smallest size decile
portfolios have a combined weight of roughly 57% (from
60% in Table 3); for the kinked concave function the
smallest size portfolio has a weight of 41.84% (from
38.3% in Table 3) while the 2 high B/M value portfolios
have a combined weight of around 42% (from 44% in
Table 3). As in the case of nonprobability distortion,
agents choose to invest the highest proportion of their
wealth to the riskiest and most profitable positively
skewed small stock portfolio for all types of preferences
(i.e., S-shaped, reverse S-shaped, kinked convex, and
assign the highest weight to the most profitable and posi-
tively skewed asset (small stock portfolio). When proba-
bility distortion is incorporated in the model, the very
small probabilities are overweighed, making such a risky
asset to seem even more attractive. This suggests that
probability distortion affects decisions (without altering
the clear preference to positively skewed assets) driving
investors to further increase the percentage of their
wealth invested to positively skewed assets and especially
to the small-stock portfolio that offers very high average
returns. These results (Tables 2–4) are also summarized
graphically in Figures 2–6.

Table 4. Optimal asset allocation: Prelec [1998] weighting function.

Value Function

S-shaped a D 0.88 Reverse S-shaped a D 1.8 Reverse S-shaped a D 1.8 Convex a D 1.8 Concave a D 0.88
b D 0.88 b D 1.8 b D 3.6 b D 0.88 b D 1.8

Panel A Style Portfolio: Market Capitalization

Small 0.3999 0.8518 0.8790 0.4003 0.4184
Dec 2 0.0038 0.1083 0.1061 0.1681 0.0009
Dec 3 0.0100 0.0042 0.0004 0.0819 0.0419
Dec 4 0.0045 0.0222 0.0047 0.0506 0.0022
Dec 5 0.0029 0.0039 0.0006 0.0021 0.0018
Dec 6 6.5462 0.0006 0.0005 0.0096 0.0030
Dec 7 0.0019 0.0006 0.0005 0.0119 0.0032
Dec 8 0.0012 0.0006 0.0005 0.0133 0.0075
Dec 9 0.0006 0.0005 0.0005 0.0149 0.0067
Large 0.0008 0.0006 0.0009 0.0060 0.0018
Panel B Style Portfolio: B/M Ratio
Growth 0.0008 0.0003 0.0007 0.0090 0.0038
Dec 2 0.0011 0.0003 0.0006 0.0131 0.0021
Dec 3 0.0008 0.0005 0.0007 0.0143 0.0046
Dec 4 0.0011 0.0003 0.0008 0.0130 0.0041
Dec 5 0.0023 0.0004 0.0005 0.0226 0.0051
Dec 6 0.0002 0.0004 0.0009 0.0172 0.0190
Dec 7 0.0003 0.0004 0.0005 0.0090 0.0025
Dec 8 0.1216 0.0006 0.0006 0.0003 0.0457
Dec 9 0.3828 0.0030 0.0971 0.0382 0.3336
Value 0.0633 0.0006 0.0008 0.1045 0.0921
Optimal Value 0.6067 0.5109 0.6477 0.8451 0.2225

Note. Optimal Asset Allocations for value functions with probability distortion (Prelec [1998]) and for various assumptions about the coefficients. The sample con-
sists of U.S. style portfolios (i.e., 10 canonical decile portfolios formed on size (market equity, ME) and 10 decile portfolios formed on value (Book to Market
Equity ratio, B/M). All data are available from Kenneth French’s online data library. Sample period: 1927–2013 (87 years).

Figure 2. Optimal asset allocation for the S-shaped value
function.
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Figure 3. Optimal asset allocation for the reverse S-shaped value
function (a).
Figure 4. Optimal asset allocation for the reverse S-shaped value
function (b).
Overall, the findings in this section indicate that (1) agents
give the maximum weight to the smallest stock portfolio; (2)
the second larger weight is given to high value stocks; (3)
when probability distortion is incorporated in the model it
seems that the very small probabilities are overweighted,
making risky positively skewed assets (and especially the
small-stock portfolio) to seem more attractive; and (4) the
used weighting function is of second importance.
Perspective value
Figure 7 presents the optimal perspective values obtained
for the different value functions of this article (S-shaped,
JOURNAL OF BEHAVIORAL FINANCE 11
Figure 5. Optimal asset allocation for the kinked convex value
function.
Figure 6. Optimal asset allocation for the kinked concave value
function.
reverse S-shaped, kinked convex, and kinked concave
value function). I obtain these optimal values as follows:
in the optimization process I employed 700 initial points
for each of the value functions; for every initial point I
obtained an optimal asset allocation and its correspond-
ing optimal perspective value through the asset allocation
model (9) and I reported the highest optimal perspective
value as the solution of the optimization problem (for
each of the value functions). Figure 8 presents a sum-
mary of these results. Their goal is to see how the optimal
perspective values are differentiated according to invest-
ors’ reward and risk attitudes represented by a specific
value function. Thus, for the S-shaped function (a D
0.88 and b D 0.88) the optimal value is around 20%
without probability distortion, around 70% with the
Kahneman and Tversky [1979] weighting function, and
around 60% with the Prelec [1998] weighting function.
For the reverse S-shaped functions the optimal value is
around 20% without probability distortion, around 60–
70% with the Kahneman and Tversky [1979] weighting
function, and around 50–60% with the Prelec [1998]
weighting function. For the kinked convex function (a D
1.8 and b D 0.88) the optimal value is around 85% with
and 28% without probability distortion, whereas for the
kinked concave value function (a D 0.88 and b D 1.8)
the optimal value is around 16% without and 22% with
probability distortion.
 12 E. K. ZERVOUDI
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Figure 7. Optimal perspective values for different value functions.

As I see there are significant differentiations among assets, which are related to highest average returns, to
the optimal perspective values from one value func- derive the greatest possible satisfaction (potential
tion to the other. The lowest optimal perspective val- seeking).
ues are obtained for the kinked concave value The probability distortion is another important factor
function. The reason behind this is that this strategy that also affects the optimal perspective values. This is so
is the least risky (i.e., agents with this type of prefer-
ences (totally risk and potential averse investors) are
the most conservative and prefer to invest higher per-
centages of their wealth to less risky assets, which are
related to lower average returns, to reduce their risk
exposure (risk and potential aversion); in this way
they sacrifice a part of their potential returns lowering
their optimal perspective values, as well. As expected,
the highest values are obtained for the kinked convex
value function. The reason behind this is that this is
the most risky strategy, that is, agents with this type
of preferences (totally risk and potential seeking
investors) are the most aggressive and prefer to invest Figure 8. Comparison of optimal perspective values for different
higher percentages of their wealth to most risky value functions.

because the objective probabilities that weight the out-
comes of the problem are too small, lowering in this way
the resulting perspective values. When probability distor-
tion is introduced, these very small probabilities are over-
weighed increasing directly the optimal perspective
values. After that, the overweighting of very small objec-
tive chances to become very wealthy by investing to posi-
tively skewed assets makes these assets more attractive to
agents driving them to increase their weights in their port-
folios, but the positively skewed assets are also related to
high average returns which implies a significant increase
to the optimal perspective values, as well.
The analysis is completed by comparing the optimal
perspective values resulting by all value functions to 2
benchmarks: (1) the average risk-free rate for the period
under examination 1927–2013 that is equal to 3.5% and
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(2) the average excess return on the market portfolio for
the same period 1927–2013 that is equal to 4.8%. The
choice of these 2 benchmarks is justified by the fact that
PT investors quite often use these rates (the average risk-
free rate and the average excess return on the market port-
folio) as reference points to evaluate their portfolios. The
results show that the optimal perspective values are much
higher than the 2 benchmarks in all cases. This finding
becomes more conspicuous when probability distortion is
introduced in the model. More specifically, the lowest
optimal perspective values obtained for the kinked con-
cave value function is around 16% without and 22% with
probability distortion (i.e., more than 4 times higher than
the average risk-free rate 3.5% without probability distor-
tion and more than 6 times higher than the average risk-
free rate 3.5% with probability distortion. Similarly, the
optimal perspective values obtained for the least risky
strategy, representing by the kinked concave value func-
tion, are more than 3 times higher than the average excess
return on the market portfolio without probability distor-
tion and more than 4 times higher than the average excess
return on the market portfolio with probability distortion.
The differentiations are impressive if we compare the opti-
mal perspective values obtained for the most risky strat-
egy, representing by the kinked convex value function, to
the 2 benchmarks (i.e., more than 8 times higher than the
average risk-free rate without probability distortion and
more than 24 times higher than the average risk-free rate
with probability distortion. Similarly, the highest optimal
perspective values are more than 5 times higher than the
average excess return on the market portfolio without
probability distortion and more than 17 times higher than
the average excess return on the market portfolio with
probability distortion.
The reason for this comparison is to give an economic
meaning to the comparative analysis of the optimal alloca-
tions and the resulting optimal perspective values for all
JOURNAL OF BEHAVIORAL FINANCE 13
value functions, with and without probability distortion.
The fact that the optimal perspective values are much
higher than the 2 benchmarks in all cases implies that PT
investors whose preferences are described by the value
functions examined in this article (S-shaped function,
reverse S-shaped functions, kinked convex function, and
kinked concave function) choose strategies that are highly
profitable and achieve returns considerably above the aver-
age market return as it is expressed by the average risk-free
rate and the average excess return on the market portfolio.
Note here that such a rate is often the benchmark return
(the pursuit) for classical risk-averse agents. This implies
that PT investors differentiate their behavior, choosing to
follow more risky but also much more profitable strategies
to derive a great satisfaction in terms of utility. This finding
may be amplified by the fact that PT agents have a clear
preference to positively skewed stocks that are considered
as quite profitable assets and thus may drive to great poten-
tial returns and very high optimal perspective values.
Conclusions
In this article, I built a general behavioral reward-risk model
that contains all the basic elements of the PT. I used 2 reward
and risk measures, the UPM and the LPM, to create different
value functions for their problem that I solved by maximiz-
ing the resulting value functions under the budget and the
short-selling constraints. I find that when agents are potential
seekers and their preferences are represented by a reverse S-
shaped or by a kinked convex value function, they assign
much higher weights (almost 86%) to the small size portfolio
(the riskiest and most profitable positively skewed asset). In
addition, they assign the second larger weight to the decile 2
portfolio formed on size, which is the second riskiest and
second most profitable positively skewed asset. In other
words, potential seekers follow very aggressive strategies and
invest almost all of their wealth in only 2 very risky and very
profitable assets to increase their potential and thus derive a
great satisfaction. The strategy is also consistent with the
clear preference of PT investors to positively skewed assets,
which are quite risky but they offer the (small) chance of sig-
nificant returns. When preferences are represented by an S-
shaped or a kinked concave value function, potential averse
investors follow more conservative strategies without altering
their clear preference to the positively skewed assets. In these
cases, agents allocate the greatest part of their wealth among
the small stocks’ portfolio (about 36%) and the high-value
portfolios (about 38% in the 2 highest value deciles). This
strategy is less aggressive than the strategy of potential
seekers in the sense that potential averse investors choose to
invest to more and less risky (but always positively skewed)
assets to reduce their risk exposure.
 14 E. K. ZERVOUDI
Probability distortion seems to affect the optimal asset
allocations, but it does not alter at all the clear preference
of PT investors to positively skewed assets, independently
of the employing weighting functional form. In fact, when
subjective probabilities are employed the optimal weights
of the most risky positively skewed assets increase. This
takes place because the objective probabilities for an agent
to become very wealthy by investing to a quite risky posi-
tively skewed asset are too small. But, when probability
distortion is incorporated in the model, the very small
probabilities are overweighted making this asset more
attractive to investors and driving them to increase the
percentages of their wealth that they invest to this asset. In
general, probability distortion increases the attractiveness
of the positively skewed assets, driving investors to
increase the weight that they give to these assets, indepen-
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dently of the employing weighting functional form.
Finally, probability distortion has a significant effect on
optimal perspective values; without probability distortion
the optimal perspective values are much lower than the
optimal perspective values with probability distortion.
This happens because without probability distortion the
objective probabilities, which weight the outcomes are too
small while with probability distortion the small probabili-
ties are overweighted, and thus the perspective values
increase significantly. The lowest optimal perspective
value (around 20% with probability distortion) is observed
in the case of the kinked concave value function, which
represents more conservative investors (large weights are
assigned to the less risky assets) and the highest optimal
perspective value (around 85% with probability distor-
tion) is observed in the case of the kinked convex value
function which represents the most aggressive investors
(large weights are assigned to the most risky assets). High
optimal perspective values are also obtained in the case of
the reverse S-shaped value function, which represents
risk-averse and potential seeking investors; the weight that
these investors give to the very profitable small stocks
portfolio is very high (around 86%), resulting quite large
returns. This is due to the potential-seeking attitude,
which makes agents to be willing to undertake greater
risks to have higher returns and thus greater satisfaction.
On the other hand, in the case of the S-shaped value func-
tion, which represents risk seeking and potential averse
investors, the optimal perspective values are smaller
because the potential aversion attitude makes agents
unwilling to undertake high risks, lowering in this way
their optimal perspective values. In general, the riskier the
strategy is, the higher the optimal perspective values are,
with and without probability distortion.
It would be useful here to point out that this article is a
general behavioral analysis that proposes a series of differ-
ent value functions for PT investors incorporated into
general behavioral reward-risk models that are solved
under the appropriate constraints. This analysis is devel-
oped into a PT framework similar to the studies of Best
and Grauer [2016] and Pirvu and Schulze [2012] that,
however, are in a different direction; these studies mostly
focused on the optimization process of a PT model under
the appropriate constrains and subsequently to the com-
parison of the resulting solutions with that of the classical
mean-variance problem. One interesting issue for future
research would be the development of the present behav-
ioral analysis into a CPT framework. The main differenti-
ation between PT and CPT is that in the PT framework
the experimental outcomes are equally likely because the
transformation is applied directly on the individual objec-
tive probabilities of the outcomes whereas in the CPT
framework equally likely outcomes may take different
probability weights because the transformation is applied
on the cumulative probabilities rather than on the individ-
ual ones (see Tversky and Kahneman [1992], Wakker and
Tversky [1993], among others). In this direction are the
working article “Theory Matters for Financial Advice!” of
Hens and Mayer [2014b] and especially the working arti-
cle “Cumulative Prospect Theory and Mean Variance
Analysis: A Rigorous Comparison” of Hens and Mayer
[2014a] in which algorithms for optimization into a CPT
framework are presented, the probability distortion is
applied on cumulative rather than on individual probabili-
ties while it is taken into account the additional non-
smoothness that is introduced in the model because of the
sorting of scenarios.
Two basic issues would make interesting the develop-
ment of the present behavioral analysis into a CPT
framework. The first main issue is that models developed
into a CPT framework may avoid the violation of the
first-order stochastic dominance rule, which practically
means that PT investors may choose dominated strate-
gies. However, there are studies such that of Rieger and
Wang [2008], which support that the violation of the
first order stochastic dominance rule is not necessarily a
problem because in descriptive decision-making theories
such as the PT, investors often choose dominated strate-
gies. Even if the most economic theories preassume
rational investors, the theory of Kahneman and Tversky
[1979] does not adopt this traditional assumption of
agents’ rationality because it is considered at most a
descriptive theory and not a normative one. The second
issue is that the PT is not continuous (i.e., small changes
in lotteries can drive to great changes in PT value). The
problem arises from the fact that the PT is applied only
on lotteries with small number of outcomes and on dis-
crete distributions. The CPT could offer a solution to
this problem since the CPT is applied on lotteries with
any number of outcomes. However, as the number of the

outcomes goes to infinity, the limit of the continuous dis-
tributions becomes independent of specific weighting
functional forms. In this way, an analysis developed into
a PT framework becomes computationally less costly
than an analysis developed into a CPT framework. This
simplification offers a significant advantage to the PT (or
the smooth PT), especially in behavioral finance where
the amounts of data (e.g., historical stock returns are
huge, comparing to the CPT that is numerically and ana-
lytically costly. From all these, it becomes clear that both
behavioral analyses developed into a PT framework and
a CPT framework are quite important and interesting.
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