Wealth Management Next Frontiers — The Inevitable Need to Meet Behavioral and Quantitative Approaches

We explain main concepts of behavioral finance within the framework of the Rational Dynamic Asset Pricing Theory (RDAPT). We discuss key modifications of the Cumulative Prospect Theory (PT) weighting function to preserve key characteristics of the price process essential for deducting derivatives pricing. We then move to value-function and provide an overview of how it relates to optimality in the framework of the Rational Finance Theory common risk and return measures such as VaR, Conditional VaR, Range-Value-at-Risk, and other related risk functions. We provide guidelines regarding how those theoretical results could be implemented and used in practice. Ultimately, the chapter bridges the gap between rational and behavioral finance by introducing both a consistent weighting function and value-function maximization criteria based on rational-finance accepted risk and return measures. Although the main motivation of the chapter has been inspired by wealth management applications, the results certainly have broader applications for both active and passive managers, such as market sentiment extraction, novel designs of quantitative strategies, as well as behavior-flavor design of ETFs and smart-beta funds.