DP5173 Performance Measurement with Loss Aversion

Author(s): Gordon T Gemmill, Soosung Hwang, Mark Salmon
Publication Date: August 2005
Keyword(s): closed-end-fund puzzle, loss aversion, performance measurement, prospect theory
JEL(s): G11, G23
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5173

We examine a simple measure of portfolio performance based on prospect theory, which captures not only risk and return but also reflects differential aversion to upside and downside risk. The measure we propose is a ratio of gains to losses, with the gains and losses weighted (if desired) to reflect risk-aversion for gains and risk-seeking for losses. It can also be interpreted as the weighted ratio of the value of a call option to a put option, with the benchmark as the exercise price. When applying the loss-aversion performance measure to closed-end funds, we find that it gives significantly different rankings from those of conventional measures (such as the Sharpe ratio, Jensen's alpha, the Sortino ratio, and the Higher Moment measure), and gives the expected signs for the odd and even moments of tracking errors. However, loss-aversion performance is not more closely related to discounts on funds than are the conventional performance measures, so we have not found evidence that loss-aversion attracts investors to particular funds in the short-term.