12/8/2023 0 Comments Power utility functionand portfolio revisions are allowed after each period. It is well-known that CRRA preferences imply that the asset allocation should be independent of the investment horizon, when returns are i.i.d. The experimental setup mimics a situation of large-stake decisions, such as savings for retirement. Based on this theoretical analysis we then experimentally study subjects’ asset allocation choices as a function of the investment horizon in a controlled setting, where the two competing preference models have very clear and very different theoretical predictions. PT is analyzed with four alternatives suggested in the literature as the reference point. We first theoretically analyze the changes in the optimal asset allocation as a function of the investment horizon for CRRA and for PT preferences, for general rate of return distributions. In this study we contrast PT with CRRA both theoretically and experimentally. PT has been supported by numerous experimental studies (typically with relatively small stakes), and can explain phenomena which are hard to rationalize in the expected utility paradigm, such as the equity premium puzzle. We focus on the two main competing preference paradigms: expected utility with Constant Relative Risk Aversion (CRRA), which is widely employed in the economic literature, and Prospect Theory (PT), which has been a dominating paradigm in the last few decades. This paper theoretically analyzes and then experimentally investigates asset allocation choices corresponding to different investment horizons. It is a question of great practical importance for investors saving for retirement. The optimal asset allocation between stocks and bonds, and its dependence on the planned investment horizon, is one of the most central issues in financial economics.
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