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Optimal Asset Allocation under Quadratic Loss Aversion

Author

Listed:
  • Fortin, Ines

    (Department of Economics and Finance, Institute for Advanced Studies, Vienna, Austria)

  • Hlouskova, Jaroslava

    (Department of Economics and Finance, Institute for Advanced Studies, Vienna, Austria, and School of Business and Economics, Thompson Rivers University, Kamloops, British Columbia, Canada)

Abstract

We study the asset allocation of a quadratic loss-averse (QLA) investor and derive conditions under which the QLA problem is equivalent to the mean-variance (MV) and conditional value-at-risk (CVaR) problems. Then we solve analytically the two-asset problem of the QLA investor for a risk-free and a risky asset. We find that the optimal QLA investment in the risky asset is finite, strictly positive and is minimal with respect to the reference point for a value strictly larger than the risk-free rate. Finally, we implement the trading strategy of a QLA investor who reallocates her portfolio on a monthly basis using 13 EU and US assets. We find that QLA portfolios (mostly) outperform MV and CVaR portfolios and that incorporating a conservative dynamic update of the QLA parameters improves the performance of QLA portfolios. Compared with linear loss-averse portfolios, QLA portfolios display significantly less risk but they also yield lower returns.

Suggested Citation

  • Fortin, Ines & Hlouskova, Jaroslava, 2012. "Optimal Asset Allocation under Quadratic Loss Aversion," Economics Series 291, Institute for Advanced Studies.
    • Handle: RePEc:ihs:ihsesp:291
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    File URL: https://irihs.ihs.ac.at/id/eprint/2161
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    References listed on IDEAS

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    Cited by:

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    More about this item

    Keywords

    Quadratic loss aversion; prospect theory; portfolio optimization; MV and CVaR portfolios; investment strategy;
    All these keywords.

    JEL classification:

    • D03 - Microeconomics - - General - - - Behavioral Microeconomics: Underlying Principles
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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