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|Title||Implications of SP/A Theory on Optimal Portfolio Choice|
|Institution||University of Zurich|
|Faculty||Faculty of Economics, Business Administration and Information Technology|
|Zusammenfassung||Portfolio choice problems are not only of great interest for practitioners, they are also regarded as a hot topic in academic literature ever since the mid-20th century. There are dozens or even hundreds of theories that attempt to describe how to choose the optimal portfolio in a financial framework. The final models of these theories often contain economical, mathematical and psychological tools. Over the past centuries, portfolio choice models encountered a vast number of developments. They became certainly more complex, but also gained in practical relevance and are widely applied in real world portfolio decisions. Yet, we are still miles away from having found the one and only model that characterizes the ideal portfolio selection process. For this, the financial markets behave too randomly and the individuals involved in there are too distinct. One should rather consider the existing theories as complements and not as substitutes. Such an approach allows for deeper astuteness of a decision process that is of high complexity. Most portfolio models have their origin in decision theory. This thesis focuses on security, potential and aspiration (SP/A) theory, which has not yet gained broad acceptance in portfolio theory. SP/A theory has been developed by the American psychologist Lola Lopes at the University of Iowa. She claims that individuals involved in decision processes associate specific feelings to security and potential. They may be either fearful (security-minded), hopeful (potential-minded) or something in between, what she calls cautiously hopeful. Furthermore, Lopes suggests that people care about aspiration, meaning that they set a predefined output level, which has to be achieved with a certain probability. The main goal of this thesis is to contribute further insights to the sparse literature of SP/A as a portfolio decision theory. It is of vital importance to thoroughly understand the theory behind decision processes. For this reason, the thesis first introduces a theoretical background and aspires to explain all SP/A parameters in detail. In a second part, I apply SP/A theory in a setup with only two assets, one of them being risky and the other one riskless. This simple two asset case is of special interest among academics. On the one hand, it provides a better understanding how different SP/A parameters influence portfolio choices and on the other hand, it easily allows to manipulate distributional assumptions of the risky asset. In particular, the impact of the first four moments (mean, variance, skewness and kurtosis) on portfolio selections is studied. Finally, the third part goes one step further and enriches the setup to the multiple asset case. Again, I outline which type of SP/A investors prefers which asset characteristics. SP/A portfolio choices of the two asset case as well as the multiple asset case are compared to benchmark portfolios based on mean-variance (MV) theory and cumulative prospect theory (CPT). The latter is also a psychological theory, which has first been introduced by Daniel Kahneman and Amos Tversky. However and in contrast to SP/A theory, it has already found wider acceptance in decision theory and it is also constantly applied to portfolio choice problems. Harry Markowitz’s MV theory is without any doubt the godfather of modern portfolio theory. Evolved in the fifties of the last century and brilliantly incorporating the idea of portfolio diversification, it is still used as a benchmark nowadays. The three key findings of my research can be described in the following way. First, SP/A theory is able to explain investor’s preferences for left- as well as right-skewed assets. In contrast, CPT predicts investor’s preferences for right-skewed assets. Such findings are not necessarily contradicting; they shall be better viewed as complements of two distinct portfolio choice approaches. In fact, outside the narrow confines of academic research, one is likely to find both types of investors. Second, the here applied clustering methods for framing the portfolio decision more realistically, do not always yield stable results. The stability of portfolio choices mainly depends on the amount of assets and their corresponding volatility, but not on correlations among them. Third, an out-of-sample analysis towards the end of the thesis indicates that portfolio strategies of potential-minded SP/A investors are able to outperform equity market indexes. This thesis is the final part of my Master of Arts in Banking and Finance at the University of Zurich. Topics in Financial Economics always caught my fascination and I am deeply grateful that I could attend classes such as Behavioral Finance, Experimental Finance or Introduction to Matlab with Applications in Finance. My ambition is to apply the theoretical knowledge gained in these classes and contribute my own enhancements to existing portfolio selection models. The portfolio decision framework developed in this thesis can be used as a basis for further research.|