Behavioral Probability Weighting and Portfolio Optimization under Semi-Heavy Tails
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arXiv
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| Main Authors: | , , , , |
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| Format: | Preprint |
| Published: |
2025
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| _version_ | 1866915373288259584 |
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| author | Jha, Ayush Shirvani, Abootaleb Jaffri, Ali M. Rachev, Svetlozar T. Fabozzi, Frank J. |
| author_facet | Jha, Ayush Shirvani, Abootaleb Jaffri, Ali M. Rachev, Svetlozar T. Fabozzi, Frank J. |
| contents | This paper develops a unified framework that integrates behavioral distortions into rational portfolio optimization by extracting implied probability weighting functions (PWFs) from optimal portfolios modeled under Gaussian and Normal-Inverse-Gaussian (NIG) return distributions. Using DJIA constituents, we construct mean-CVaR99 frontiers, alongwith Sharpe- and CVaR-maximizing portfolios, and estimate PWFs that capture nonlinear beliefs consistent with fear and greed. We show that increasing tail fatness amplifies these distortions and that shifts in the term structure of risk-free rates alter their curvature. The results highlight the importance of jointly modeling return asymmetry and belief distortions in portfolio risk management and capital allocation under extreme-risk environments. |
| format | Preprint |
| id |
arxiv_https___arxiv_org_abs_2507_04208 |
| institution | arXiv |
| publishDate | 2025 |
| record_format | arxiv |
| spellingShingle | Behavioral Probability Weighting and Portfolio Optimization under Semi-Heavy Tails Jha, Ayush Shirvani, Abootaleb Jaffri, Ali M. Rachev, Svetlozar T. Fabozzi, Frank J. General Economics Economics Portfolio Management Risk Management This paper develops a unified framework that integrates behavioral distortions into rational portfolio optimization by extracting implied probability weighting functions (PWFs) from optimal portfolios modeled under Gaussian and Normal-Inverse-Gaussian (NIG) return distributions. Using DJIA constituents, we construct mean-CVaR99 frontiers, alongwith Sharpe- and CVaR-maximizing portfolios, and estimate PWFs that capture nonlinear beliefs consistent with fear and greed. We show that increasing tail fatness amplifies these distortions and that shifts in the term structure of risk-free rates alter their curvature. The results highlight the importance of jointly modeling return asymmetry and belief distortions in portfolio risk management and capital allocation under extreme-risk environments. |
| title | Behavioral Probability Weighting and Portfolio Optimization under Semi-Heavy Tails |
| topic | General Economics Economics Portfolio Management Risk Management |
| url | https://arxiv.org/abs/2507.04208 |