A short note on Perceived Risk

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09-09-2022
DREAM Peter Stephensen

In standard porfolio theory, mean-variance analysis is used to assamble a portfolio of assets such that the expected return is maximized for a given level of risk. In this note we give a behavioral version of the same story.

Abstract

In standard porfolio theory, mean-variance analysis is used to assamble a portfolio of assets such that the expected return is maximized for a given level of risk (Markowitz, 1952). In this note we give a behavioral version of the same story. The investors risk preferences is described by a Percieved-Risk-function. According to this function, more risk is associated with investing more, and investing un-deversified. It is demonstrated that if this function is a Constant Elasticity of Transformation function (CET function), the fortfolio problem has a simple analytical solution.