The Risk-Return Paradox in Local Government Investing

This study contrasts expected utility theory in the form of modern portfolio theory (MPT) with a descriptive psychological analysis in the form of prospect theory. For local government investment managers, the assumptions underlying MPT are violated in the manner predicted by prospect theory. Findings confirm the notion that local government investment managers are risk-averse when facing an investment gain and risk-seeking when facing an investment loss. Although a number of researchers have appealed to prospect theory to explain firm and industry risk patterns, the utility of prospect theory in public sector organizations is questioned. This study finds that irrespective of their personal disposition toward risk, local government chief investment officers defer to a compelling public interest when making investment decisions for their organization.