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Downside Loss Aversion and Portfolio Management

  • Robert Jarrow

    ()

    (Johnson Graduate School of Management, Cornell University, Ithaca, New York 14853)

  • Feng Zhao

    ()

    (Rutgers Business School, Rutgers University, Newark, New Jersey 07102)

Downside loss-averse preferences have seen a resurgence in the portfolio management literature. This is due to the increasing use of derivatives in managing equity portfolios and the increased use of quantitative techniques for bond portfolio management. We employ the lower partial moment as a risk measure for downside loss aversion and compare mean-variance (M-V) and mean-lower partial moment (M-LPM) optimal portfolios under nonnormal asset return distributions. When asset returns are nearly normally distributed, there is little difference between the optimal M-V and M-LPM portfolios. When asset returns are nonnormal with large left tails, we document significant differences in M-V and M-LPM optimal portfolios. This observation is consistent with industry usage of M-V theory for equity portfolios but not for fixed-income portfolios.

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File URL: http://dx.doi.org/10.1287/mnsc.1050.0486
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Article provided by INFORMS in its journal Management Science.

Volume (Year): 52 (2006)
Issue (Month): 4 (April)
Pages: 558-566

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Handle: RePEc:inm:ormnsc:v:52:y:2006:i:4:p:558-566
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