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"Prospect Theory in International Relations" published on by Oxford University Press.

We study the asset allocation of an investor with prospect theory (PT) preferences. First, we solve analytically the two-asset problem of the PT investor for one risk-free and one risky asset and find that loss aversion and the reference return affect differently less ambitious investors and more ambitious investors. Second, we empirically investigate the performance of a PT portfolio when diversifying among a stock market index, a government bond and gold, in Europe and the US. We focus on investors with PT preferences under different scenarios regarding the reference return and the degree of loss aversion and compare their portfolio performance with the performance of investors under CVaR, risk neutral, linear loss averse and in particular mean-variance (MV) preferences. We find that, in the US, PT portfolios significantly outperform (in terms of returns) mean-variance portfolios in the majority of cases. Also with respect to riskadjusted performance, PT investment outperforms MV investment in the US. Similar results, however, can not be observed in Europe. Finally, we analyze asymmetric effects along economic uncertainty and observe that PT investment leads to higher returns than MV investment in times of larger economic uncertainty, especially in the US.

We study the asset allocation of an investor with prospect theory (PT) preferences. First, we solve analytically the two-asset problem of the PT investor for one risk-free and one risky asset and find that loss aversion and the reference return affect differently less ambitious investors and more ambitious investors. Second, we empirically investigate the performance of a PT portfolio when diversifying among a stock market index, a government bond and gold, in Europe and the US. We focus on investors with PT preferences under different scenarios regarding the reference return and the degree of loss aversion and compare their portfolio performance with the performance of investors under CVaR, risk neutral, linear loss averse and in particular mean-variance (MV) preferences. We find that, in the US, PT portfolios signiffcantly outperform (in terms of returns) mean-variance portfolios in the majority of cases. Also with respect to riskadjusted performance, PT investment outperforms MV investment in the US. Similar results, however, can not be observed in Europe. Finally, we analyze asymmetric effects along economic uncertainty and observe that PT investment leads to higher returns than MV investment in times of larger economic uncertainty, especially in the US.

Despite many applications of prospect theory's concepts to explain political and strategic phenomena, formal analyses of strategic problems using prospect theory are rare. Using Fearon's model of bargaining, Tversky and Kahneman's value function, and an existing probability weighting function, I construct a model that demonstrates the differences between expected value and prospect theory when applied to strategic interaction. Critically important to this demonstration is an examination of different types of reference points that make sense for bargaining problems. Four types of reference points are discussed and analyzed: power-based, equity, variants of the status quo, and extreme ``I-want-it-all'' reference points. Each of these types of reference points produce different bargaining behavior at the individual level and in combination with the type of reference point of the other actor. Additionally, I demonstrate that bargaining failure is possible for this model under complete and perfect information using prospect-theoretic logic.

Prospect theory is the most influential behavioral theory of choice in the social sciences. Its creators won a Nobel Prize in economics, & it is largely responsible for the booming field of behavioral economics. Although international relations theorists who study security have used prospect theory extensively, Americanists, comparativists, & political economists have shown little interest in it. The dominant explanation for political scientists' tepid response focuses on the theoretical problems with extending a theory devised in the lab to explain political decisions in the field. This essay focuses on these problems & reviews suggested solutions. It suggests that prospect theory's failure to ignite the imagination of more political scientists probably results from their aversion to behavioral assumptions & not from problems unique to prospect theory. 92 References. Adapted from the source document.