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Delivering Left-Skewed Portfolio Payoff Distributions in the Presence of Transaction Costs

Listed author(s):
  • Jacek B Krawczyk

    ()

    (Victoria University of Wellington, School of Economics and Finance, PO Box 600, Wellington 6140, New Zealand)

For pension-savers, a low payoff is a financial disaster. Such investors will most likely prefer left-skewed payoff distributions over right-skewed payoff distributions. We explore how such distributions can be delivered. Cautious-relaxed utility measures are cautious in ensuring that payoffs don’t fall much below a reference value, but relaxed about exceeding it. We find that the payoff distribution delivered by a cautious-relaxed utility measure has appealing features which payoff distributions delivered by traditional utility functions don’t. In particular, cautious-relaxed distributions can have the mass concentrated on the left, hence be left-skewed. However, cautious-relaxed strategies prescribe frequent portfolio adjustments which may be expensive if transaction costs are charged. In contrast, more traditional strategies can be time-invariant. Thus we investigate the impact of transaction costs on the appeal of cautious-relaxed strategies. We find that relatively high transaction fees are required for the cautious-relaxed strategy to lose its appeal. This paper contributes to the literature which compares utility measures by the payoff distributions they produce and finds that a cautious-relaxed utility measure will deliver payoffs that many investors will prefer.

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Article provided by MDPI, Open Access Journal in its journal Risks.

Volume (Year): 3 (2015)
Issue (Month): 3 (August)
Pages: 1-20

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Handle: RePEc:gam:jrisks:v:3:y:2015:i:3:p:318-337:d:54631
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  1. Alistair Windsor & Jacek B. Krawczyk, 1997. "A Matlab Package for Approximating the Solution to a Continuous- Time Stochastic Optimal Control Problem," Computational Economics 9710002, EconWPA.
  2. 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.
  3. Bali, Turan G. & Cakici, Nusret & Whitelaw, Robert F., 2011. "Maxing out: Stocks as lotteries and the cross-section of expected returns," Journal of Financial Economics, Elsevier, vol. 99(2), pages 427-446, February.
  4. Foster, Jarred, 2011. "Target variation in a loss avoiding pension fund problem," MPRA Paper 36177, University Library of Munich, Germany.
  5. Arjan B. Berkelaar & Roy Kouwenberg & Thierry Post, 2004. "Optimal Portfolio Choice under Loss Aversion," The Review of Economics and Statistics, MIT Press, vol. 86(4), pages 973-987, November.
  6. Nicholas Barberis & Ming Huang, 2008. "Stocks as Lotteries: The Implications of Probability Weighting for Security Prices," American Economic Review, American Economic Association, vol. 98(5), pages 2066-2100, December.
  7. Jacek B. Krawczyk, 2000. "A Markovian Approximated Solution To A Portfolio Management Problem," Computing in Economics and Finance 2000 233, Society for Computational Economics.
  8. Azzato, Jeffrey & Krawczyk, Jacek B & Sissons, Christopher, 2011. "On loss-avoiding lump-sum pension optimization with contingent targets," Working Paper Series 1532, Victoria University of Wellington, School of Economics and Finance.
  9. Merton, Robert C., 1971. "Optimum consumption and portfolio rules in a continuous-time model," Journal of Economic Theory, Elsevier, vol. 3(4), pages 373-413, December.
  10. Hanqing Jin & Xun Yu Zhou, 2008. "Behavioral Portfolio Selection In Continuous Time," Mathematical Finance, Wiley Blackwell, vol. 18(3), pages 385-426.
  11. Jacek B. Krawczyk, 2008. "On loss-avoiding payoff distribution in a dynamic portfolio management problem," Journal of Risk Finance, Emerald Group Publishing, vol. 9(2), pages 151-172, February.
  12. Paul A. Samuelson, 2011. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," World Scientific Book Chapters,in: THE KELLY CAPITAL GROWTH INVESTMENT CRITERION THEORY and PRACTICE, chapter 31, pages 465-472 World Scientific Publishing Co. Pte. Ltd..
  13. Azzato, Jeffrey D. & Krawczyk, Jacek B., 2008. "A parallel Matlab package for approximating the solution to a continuous-time stochastic optimal control problem," MPRA Paper 9993, University Library of Munich, Germany.
  14. David Blake, 1999. "Portfolio Choice Models of Pension Funds and Life Assurance Companies: Similarities and Differences," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan;The Geneva Association, vol. 24(3), pages 327-357, July.
  15. Bernard, Carole & Chen, Jit Seng & Vanduffel, Steven, 2015. "Rationalizing investors’ choices," Journal of Mathematical Economics, Elsevier, vol. 59(C), pages 10-23.
  16. Daniel G. Goldstein & Eric J. Johnson & William F. Sharpe, 2008. "Choosing Outcomes versus Choosing Products: Consumer-Focused Retirement Investment Advice," Journal of Consumer Research, Oxford University Press, vol. 35(3), pages 440-456, August.
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