Continuous-time behavioral portfolio selection

This paper formulates and studies a general continuous-time behavioral portfolio selection model under Kahneman and Tversky's (cumulative) prospect theory, featuring S-shaped utility (value) functions and probability distortions. The optimal terminal wealth positions, derived in fairly explicit forms, possess surprisingly simple structure: they resemble the payoff of a portfolio of two binary (or digital) options written on the state density price. An example with a two-piece CRRA utility is presented to illustrate the general results obtained, and is solved completely for all installations of the parameters. The effect of the behavioral criterion on the risky allocations is finally discussed. © 2008 IEEE.