Working Paper: CEPR ID: DP5173
Authors: Gordon T. Gemmill; Soosung Hwang; Mark Salmon
Abstract: We examine a simple measure of portfolio performance based on prospect theory, which captures not only risk and return but also reflects differential aversion to upside and downside risk. The measure we propose is a ratio of gains to losses, with the gains and losses weighted (if desired) to reflect risk-aversion for gains and risk-seeking for losses. It can also be interpreted as the weighted ratio of the value of a call option to a put option, with the benchmark as the exercise price. When applying the loss-aversion performance measure to closed-end funds, we find that it gives significantly different rankings from those of conventional measures (such as the Sharpe ratio, Jensen's alpha, the Sortino ratio, and the Higher Moment measure), and gives the expected signs for the odd and even moments of tracking errors. However, loss-aversion performance is not more closely related to discounts on funds than are the conventional performance measures, so we have not found evidence that loss-aversion attracts investors to particular funds in the short-term.
Keywords: closed-end fund; puzzle; loss aversion; performance measurement; prospect theory
JEL Codes: G11; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| loss-aversion performance measure (LAP) (G41) | portfolio performance ranking (G11) |
| loss-aversion performance measure (LAP) (G41) | relationship between gains and losses (G41) |
| loss-aversion performance measure (LAP) (G41) | psychological aspects of investor decision-making (G41) |
| loss-aversion performance measure (LAP) (G41) | tracking error (Y10) |
| conventional performance measures (L25) | fund discounts (G23) |
| investor sentiment (G41) | performance measures (C52) |
| loss-aversion performance measure (LAP) (G41) | understanding investor behavior (G41) |