Optimal Investment Management for Prospect Theory Investors

Abstract

Suppose an investment manager has discretion to allocate the timing of client contributions or management fees over a calendar year. If her client has prospect theory preferences and anchors gains and losses to the previous account balance, then the manager's optimal timing of account inflows and outflows can increase client satisfaction. The optimal strategies allocate contributions to offset small portfolio losses and charge fees to offset large portfolio gains. I compare the optimal strategies to strategies that allocate contributions or charge fees equally every quarter or month. The client is indifferent between contributing 1.4% to 1.6% allocated equally and contributing 1% allocated optimally. The client is indifferent between paying fees of 0.58% to 0.70% assessed equally and paying fees of 1% assessed optimally. Investment managers who structure contributions and fees to target prospect theory preferences and the anchoring effect can increase individual investor savings and institutional management fees.