Choosing investment solutions for South African long-term investors with prospect theory-type risk preferences
Thesis (MCom)--Stellenbosch University, 2020.
ENGLISH ABSTRACT : This thesis investigates the optimal choice of investment style for a representative long term South African investor assuming a Prospect Theory-type utility functions. The relative performance of Balanced Funds, Absolute Return Funds, General Equity Funds, and Flexible Funds were investigated in this context. A fundamental insight of Prospect Theory is that human beings are more responsive to losses than gains, as demonstrated by the S-shaped value function. These subtleties are ignored by Expected Utility Theory and their associated risk measures (most importantly, variance) may lead to portfolio designs that are inconsistent with investors’ risk preferences. Two methods for investigating the optimal investment style for these investors were applied (namely, Historical Analysis and Filtered Historical Simulations). The Historical Analysis method reveals that Balanced Funds offer the highest returns, but the Sharpe ratio shows that Absolute Return Funds have the best risk-return trade off. Using Prospect theorybased utility functions with differing parameters reflecting differing risk preferences, the Filtered Historical Simulation method reveals that Absolute Return Funds are most likely to be the optimal investment style for an investor exhibiting either severe or mild “loss aversion”. For investors with “no loss aversion”, the optimal investment style is Balanced Funds which deliver the highest expected cumulative utility. This study shows that the choice of investment style is dependent on the level of loss aversion. This suggests the need to estimate these for South African investors as the parameters used in this study are derived from international studies that are relatively dated.
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