Behavioral Finance for Private Banking, 2nd Edition

CHAPTER 6Decision Theory

6.1 INTRODUCTION

According to a famous study by Ibbotson & Kaplan (2000), the strategic asset allocation (SAA) determines more than 90% of the performance of an investor. This is true, however, only if the investors hold on their asset allocation over the stock market cycle. There is ample evidence that investors depart from the asset allocation recommended to them when they incur losses.¹ Thus, the question arises as to how to tailor an asset allocation that investors do really hold through.

This chapter lays the foundation for computing the SAA of private investors that best suits their investment psychology. It assumes that the returns of assets can be described by the probabilities with which they occur—that is, that we face a decision under risk. If this assumption cannot be made, we face a decision under uncertainty and it is better to evoke qualitative reasoning rather than doing sophisticated computations.²

The most famous psychologically founded decision theory is prospect theory of Kahneman and Tversky (1979). Before we dive into prospect theory, it is useful to recap the history of decision theory. In particular, expected utility theory, which goes back to Bernoulli (1738) and to von Neumann & Morgenstern (1944), is an important precedent of prospect theory. Moreover, most practitioners know the mean‐variance analysis of Markowitz (1952) so that it is useful to also put this into perspective.

6.2 A (VERY) SHORT HISTORY OF DECISION THEORY ...