IDEAS home Printed from https://ideas.repec.org/a/eee/jbfina/v35y2011i11p2974-2990.html
   My bibliography  Save this article

Optimal asset allocation under linear loss aversion

Author

Listed:
  • Fortin, Ines
  • Hlouskova, Jaroslava

Abstract

We study the asset allocation of a linear loss-averse (LA) investor and compare it to the more traditional mean-variance (MV) and conditional value-at-risk (CVaR) investors. First we derive conditions under which the LA problem is equivalent to the MV and CVaR problems and solve analytically the two-asset problem of the LA investor for a risk-free and a risky asset. Then we run simulation experiments to study properties of the optimal LA and MV portfolios under more realistic assumptions. We find that under asymmetric dependence LA portfolios outperform MV portfolios, provided investors are sufficiently loss-averse and dependence is large. Finally, using 13 EU and US assets, we implement the trading strategy of a linear LA investor who reallocates his/her portfolio on a monthly basis. We find that LA portfolios clearly outperform MV and CVaR portfolios and that incorporating a dynamic update of the LA parameters significantly improves the performance of LA portfolios.

Suggested Citation

  • Fortin, Ines & Hlouskova, Jaroslava, 2011. "Optimal asset allocation under linear loss aversion," Journal of Banking & Finance, Elsevier, vol. 35(11), pages 2974-2990, November.
  • Handle: RePEc:eee:jbfina:v:35:y:2011:i:11:p:2974-2990
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0378426611001282
    Download Restriction: Full text for ScienceDirect subscribers only

    As the access to this document is restricted, you may want to look for a different version below or search for a different version of it.

    Other versions of this item:

    References listed on IDEAS

    as
    1. Berkelaar, Arjan & Kouwenberg, Roy, 2009. "From boom 'til bust: How loss aversion affects asset prices," Journal of Banking & Finance, Elsevier, vol. 33(6), pages 1005-1013, June.
    2. Hwang, Soosung & Satchell, Steve E., 2010. "How loss averse are investors in financial markets?," Journal of Banking & Finance, Elsevier, vol. 34(10), pages 2425-2438, October.
    3. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, March.
    4. repec:sae:ecolab:v:16:y:2006:i:2:p:1-2 is not listed on IDEAS
    5. Shlomo Benartzi & Richard H. Thaler, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, Oxford University Press, vol. 110(1), pages 73-92.
    6. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-291, March.
    7. De Bondt, Werner F M & Thaler, Richard, 1985. " Does the Stock Market Overreact?," Journal of Finance, American Finance Association, vol. 40(3), pages 793-805, July.
    8. Ulrich Schmidt & Chris Starmer & Robert Sugden, 2008. "Third-generation prospect theory," Journal of Risk and Uncertainty, Springer, vol. 36(3), pages 203-223, June.
    9. Tversky, Amos & Kahneman, Daniel, 1992. "Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
    10. Terrance Odean, 1998. "Are Investors Reluctant to Realize Their Losses?," Journal of Finance, American Finance Association, vol. 53(5), pages 1775-1798, October.
    11. Gurevich, Gregory & Kliger, Doron & Levy, Ori, 2009. "Decision-making under uncertainty - A field study of cumulative prospect theory," Journal of Banking & Finance, Elsevier, vol. 33(7), pages 1221-1229, July.
    12. Nikolay Nenovsky & S. Statev, 2006. "Introduction," Post-Print halshs-00260898, HAL.
    13. S. Dellavigna., 2011. "Psychology and Economics: Evidence from the Field," VOPROSY ECONOMIKI, N.P. Redaktsiya zhurnala "Voprosy Economiki", vol. 5.
    14. Nicholas Barberis, 2001. "Mental Accounting, Loss Aversion, and Individual Stock Returns," Journal of Finance, American Finance Association, vol. 56(4), pages 1247-1292, August.
    15. Francisco J. Gomes, 2005. "Portfolio Choice and Trading Volume with Loss-Averse Investors," The Journal of Business, University of Chicago Press, vol. 78(2), pages 675-706, March.
    16. Levy, Haim & Levy, Moshe, 2009. "The safety first expected utility model: Experimental evidence and economic implications," Journal of Banking & Finance, Elsevier, vol. 33(8), pages 1494-1506, August.
    17. Nicholas Barberis & Ming Huang, 2001. "Mental Accounting, Loss Aversion, and Individual Stock Returns," NBER Working Papers 8190, National Bureau of Economic Research, Inc.
    18. Nicholas Barberis & Ming Huang & Tano Santos, 2001. "Prospect Theory and Asset Prices," The Quarterly Journal of Economics, Oxford University Press, vol. 116(1), pages 1-53.
    19. Enrico Giorgi & Thorsten Hens, 2006. "Making prospect theory fit for finance," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 20(3), pages 339-360, September.
    20. Enrico Giorgi & Thorsten Hens & János Mayer, 2007. "Computational aspects of prospect theory with asset pricing applications," Computational Economics, Springer;Society for Computational Economics, vol. 29(3), pages 267-281, May.
    21. Zhang, Wenlang & Semmler, Willi, 2009. "Prospect theory for stock markets: Empirical evidence with time-series data," Journal of Economic Behavior & Organization, Elsevier, vol. 72(3), pages 835-849, December.
    22. Haim Levy & Enrico De Giorgi & Thorsten Hens, "undated". "Prospect Theory and the CAPM: A contradiction or coexistence?," IEW - Working Papers 157, Institute for Empirical Research in Economics - University of Zurich.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. repec:wsi:ijfexx:v:04:y:2017:i:02n03:n:s2424786317500360 is not listed on IDEAS
    2. Matteo Del Vigna, 2012. "Stochastic dominance for law invariant preferences: The happy story of elliptical distributions," Working Papers - Mathematical Economics 2012-08, Universita' degli Studi di Firenze, Dipartimento di Scienze per l'Economia e l'Impresa.
    3. Grauer, Robert R., 2013. "Limiting losses may be injurious to your wealth," Journal of Banking & Finance, Elsevier, vol. 37(12), pages 5088-5100.
    4. Curatola, Giuliano, 2016. "Optimal consumption and portfolio choice with loss aversion," SAFE Working Paper Series 130, Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.
    5. Fortin, Ines & Hlouskova, Jaroslava & Tsigaris, Panagiotis, 2016. "The Consumption-Investment Decision of a Prospect Theory Household," Economics Series 322, Institute for Advanced Studies.
    6. repec:wsi:qjfxxx:v:07:y:2017:i:02:n:s201013921750001x is not listed on IDEAS
    7. Guidolin, Massimo & Hyde, Stuart, 2012. "Can VAR models capture regime shifts in asset returns? A long-horizon strategic asset allocation perspective," Journal of Banking & Finance, Elsevier, vol. 36(3), pages 695-716.
    8. Liu, Shuangzhe & Ma, Tiefeng & Polasek, Wolfgang, 2014. "Spatial system estimators for panel models: A sensitivity and simulation study," Mathematics and Computers in Simulation (MATCOM), Elsevier, vol. 101(C), pages 78-102.
    9. Jaroslava Hlouskova & Panagiotis Tsigaris & Anetta Caplanova & Rudolf Sivak, 2017. "A behavioral portfolio approach to multiple job holdings," Review of Economics of the Household, Springer, vol. 15(2), pages 669-689, June.
    10. Matteo Del Vigna, 2011. "Financial market equilibria with heterogeneous agents: CAPM and market segmentation," Working Papers - Mathematical Economics 2011-08, Universita' degli Studi di Firenze, Dipartimento di Scienze per l'Economia e l'Impresa.
    11. Michael Best & Robert Grauer & Jaroslava Hlouskova & Xili Zhang, 2014. "Loss-Aversion with Kinked Linear Utility Functions," Computational Economics, Springer;Society for Computational Economics, vol. 44(1), pages 45-65, June.
    12. Fulga, Cristinca, 2016. "Portfolio optimization under loss aversion," European Journal of Operational Research, Elsevier, vol. 251(1), pages 310-322.
    13. Zhichao Zhang & Frankie Chau & Li Xie, 2013. "Accumulation of large foreign reserves in China: a behavioural perspective," Economic Change and Restructuring, Springer, vol. 46(1), pages 85-108, March.
    14. repec:eee:mateco:v:70:y:2017:i:c:p:74-89 is not listed on IDEAS
    15. Crespo Cuaresma, Jesus & Fortin, Ines & Hlouskova, Jaroslava, 2017. "Exchange rate forecasting and the performance of currency portfolios," Economics Series 326, Institute for Advanced Studies.
    16. repec:eee:quaeco:v:66:y:2017:i:c:p:345-358 is not listed on IDEAS
    17. Jaroslava Hlouskova & Jana Mikocziova & Rudolf Sivak & Peter Tsigaris, 2014. "Capital Income Taxation and Risk-Taking under Prospect Theory: The Continuous Distribution Case," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 64(5), pages 374-391, November.
    18. Ines Fortin & Jaroslava Hlouskova, 2015. "Downside loss aversion: Winner or loser?," Mathematical Methods of Operations Research, Springer;Gesellschaft für Operations Research (GOR);Nederlands Genootschap voor Besliskunde (NGB), vol. 81(2), pages 181-233, April.
    19. Behr, Patrick & Guettler, Andre & Truebenbach, Fabian, 2012. "Using industry momentum to improve portfolio performance," Journal of Banking & Finance, Elsevier, vol. 36(5), pages 1414-1423.
    20. Fortin, Ines & Hlouskova, Jaroslava, 2012. "Optimal Asset Allocation under Quadratic Loss Aversion," Economics Series 291, Institute for Advanced Studies.
    21. Fulga, Cristinca, 2016. "Portfolio optimization with disutility-based risk measure," European Journal of Operational Research, Elsevier, vol. 251(2), pages 541-553.

    More about this item

    Keywords

    D03 D81 G11 G15 G24 Loss aversion Prospect theory Portfolio optimization MV/CVaR portfolios Copula Investment strategy;

    JEL classification:

    • 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

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:jbfina:v:35:y:2011:i:11:p:2974-2990. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Dana Niculescu). General contact details of provider: http://www.elsevier.com/locate/jbf .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.