Contextual utility framework Application in portfolio diversification theory

Abstract

Purpose: Arrow-Debreu’s seminal works generated the field of portfolio diversification theory, followed by seminal works of CAPM and allied models. However, it has been observed since past decades that CAPM and allied frame works have not predicted well the investment behaviors under contexts like uncertainty. Recently quantum-like modelling or quantum decision theory has been formulated to account for choice behavior under contexts, which is a comprehensive decision-making framework based on quantum logic rather than standard Boolean logic. This short paper provides a possible set up for portfolio choice behavior under contexts based upon the very frame work.

Design/ Methodology/ Approach: model proposed is based on the Hilbert space modelling framework of quantum decision theory. Some parallels with Ellsberg paradox in decision theory is emphasized.

Findings: This paper is a theoretical model, which aims in overcoming limitations of neoclassical diversification theory by improving the descriptive and predictive power of the theory. Overall, the current paper can be positioned within the Econophysical and Quantum-like modelling paradigms which are attempts to build a more comprehensive Economic theory.

Research limitations: The author accepts that the theoretical model proposed here needs to be tested, suitable data analysis would be the next immediate step to follow.

Originality/ Value: one, to propose a novel application of quantum decision theory/ framework to a pressing real-world problem of portfolio diversification, which is crucial for investors, two, also to raise awareness among main stream practitioners of economic theory about the emerging field of quantum-like modelling in economics and finance.