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DYNAMIC COOPERATIVE INVESTMENT BY PROSPECT THEORY
Keywords:
Pareto optimal, certainty equivalent, prospect theory, dynamic system, cooperative investmentDOI:
https://doi.org/10.17654/0974165825036Abstract
This paper examines investor behavior using probability functions and establishes a consistent mean-variance model based on compound independent axioms with unique certainty equivalency $C = u^(-1)(E(u(X)]$.
An alternate strategy is presented to solve cooperative investment dynamically for the mean-variance utility function. An explicit formula based on the exponential utility function over the normal distribution is established to approximate the certainty equivalent for each investor corresponding to the mean-variance utility function. Additionally, alternative decision-making theories, such as prospect theory, are defined to apply in solving cooperative investment schemes by considering investors’ preferences as a function of choice, assuming that weight does not always coincide with probability. Prospect Theory (PT) suggests that decision weight tends to underweight moderate and high probabilities and overweight small ones. Furthermore, the Prospect Theory Approach can be used to align investors’ perceptions of risk with logical decision-making through suitable modeling. A numerical experiment using S&P100 data is also displayed.
Received: August 29, 2024
Revised: May 13, 2025
Accepted: May 31, 2025
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