Prospect theory, constant relative risk aversion, and the investment horizon.

Abstract

Prospect Theory (PT) and Constant-Relative-Risk-Aversion (CRRA) preferences have clear-cut and very different implications for the optimal asset allocation between a riskless asset and a risky stock as a function of the investment horizon. While CRRA implies that the optimal allocation is independent of the horizon, we show that PT implies a dramatic and discontinuous "jump" in the optimal allocation as the horizon increases. We experimentally test these predictions at the individual level. We find rather strong support for CRRA, but very little support for PT.