Tracking error decision rules and accumulated wealth
There is compelling evidence that typical decision-makers, including individual investors and even professional money managers, care about the difference between their portfolio returns and a reference point, or benchmark return. In the context of financial markets, likely benchmarks against which investors compare their own returns include easy-to-focus-on numbers such as one's own past payoffs, historical average payoffs, and the payoffs of competitors. Referring to the gap between one's current portfolio return and the benchmark return as 'tracking error', this paper develops a simple model to study the consequences and possible origins of investors who use expected tracking error to guide their portfolio decisions, referred to as 'tracking error types'. In particular, this paper analyses the level of risk-taking and accumulated wealth of tracking error types using standard mean-variance investors as a comparison group. The behaviour of these two types are studied first in isolation, and then in an equilibrium model. Simple analytic results together with statistics summarizing simulated wealth accumulations point to the conclusion that tracking error—whether it is interpreted as reflecting inertia, habituation, or a propensity to make social comparisons in evaluating one's own performance—leads to greater risk-taking and greater shares of accumulated wealth. This result holds even though the two types are calibrated to be identically risk-averse when expected tracking error equals zero. In the equilibrium model, increased aggregate levels of risk-taking reduce the returns on risk. Therefore, the net social effect of tracking-error-induced risk-taking is potentially ambiguous. This paper shows, however, that tracking error promotes a pattern of specialization that helps the economy move towards the path of maximum accumulated wealth.
If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.
Volume (Year): 10 (2003)
Issue (Month): 2 ()
|Contact details of provider:|| Web page: http://www.tandfonline.com/RAMF20|
|Order Information:||Web: http://www.tandfonline.com/pricing/journal/RAMF20|
When requesting a correction, please mention this item's handle: RePEc:taf:apmtfi:v:10:y:2003:i:2:p:91-119. 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: (Michael McNulty)
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 references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link 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 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.