I don't understand this. (Prospect theory detection of dominance)

CFA Level III Portfolio Management
#1

Detection of Dominance: Outcomes that are strictly dominated are scanned and rejected without further evaluation. Why reject? I’d rather accept it.

#2

Outcomes being dominated should be rejected yes.

#3

Consider these two outcomes

Outcome 1: it offers a return of 10% and a SD of return of 20%

Outcome 2: it offers a return of 12% and a SD of return of 20%

Outcome 2 dominates the outcome 1, because you can earn more return for the same level of risk. Think of all the portofolios under the mean variance frontier; the portofolios above strictly dominate the portofolios below the efficient frontier. (If you choose to select outcome 1, please contact me ASAP, because I would like to engage in some swaps trading withyou :).

Now consider this scenario

Outcome 1: it offers a return of 10% and SD of return of 20%

Outcome 2: it offers a return of 10% and SD of return of 10%

In this case, you can’t say that outcome 2 dominates outcome 1. A risk seeking investor might think that a high SD is preferable over a low SD. This is not a case of outcome 2 strictly dominating outcome 1.

#4

Consider the first scenario. Outcome 2 dominates outcome1.

Which one will you accept vs which one will you reject under prospect theory?

Thanks

#5

you have to understand that detection of dominance is part of the editing phase in prospect theory. What does editing mean? In simple terms, it means using a few rules (there are 6 listed in the book), that would make your decision making easier. One of those rules is detection of dominance, and it’s applied when comparing multiple prospects.

So when thinking about the first scenario, you will obviously reject outcome 1. It gives you a lower return for the same risk and return that outcome 2 has.

using the same logic, you will also reject any portofolios under the efficient frontier because they give inferior return/risk relative to portofolios on the efficient frontier.

#6

Dominated - passive form —> being dominated by other options, thus rejected.

#7

Got it. Thanks!!

Damn you english language!!

#8

thank you all!

I kept thinking “dominating” when i read “dominated” which was the confusion.

#9

Yes, English is not my first language, but rather third so I figured that you read it incorrectly