Behavioral Finance Driven Investment Strategies

Rudi Zagst

Portfolio-insurance strategies, such as the constant-proportion portfolio insurance (CPPI), as well as liability-driven investment strategies (LDI) are economically important to investors like insurance companies and pension funds. However, non-anticipated shocks in stock prices, negative interest rates or overnight trading restrictions could drop portfolio values below desired levels making the application of a CPPI impossible or an LDI underfunded. We consider behavioral aspects from cumulative prospect theory (CPT), in particular risk-averse behavior for gains, risk-seeking behavior for losses and probability distortion, and develop optimal investment strategies that allow for situations of falling short a given benchmark or being underfunded. We compare the optimal investment strategies to the standard CPPI and traditional LDI approaches.