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Optimal Asset Allocation Based on Utility Maximization in the Presence of Market Frictions

  • Alessandro Bucciol
  • Raffaele Miniaci

We develop a model of optimal asset allocation based on a utility framework. This applies to a more general context than the classical mean-variance paradigm since it can also account for the presence of constraints in the portfolio composition. Using this approach, we study the distribution of a measure of wealth compensative variation, we propose a benchmark and portfolio efficiency test and a procedure to estimate the implicit risk aversion parameter of a power utility function. Our empirical analysis makes use of the S&P 500 and industry portfolios time series to show that although the market index cannot be considered an efficient investment in the mean-variance metric, the wealth loss associated with such an investment is statistically different from zero but rather small (lower than 0.5%). The wealth loss is at its minimum for a representative agent with a constant risk aversion index not higher than 5. Furthermore we show that, for reasonable levels of risk aversion, the use of an equally weighted portfolio is surprisingly consistent with an expected utility maximizing behavior.

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Paper provided by University of Brescia, Department of Economics in its series Working Papers with number ubs0605.

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Date of creation: 2006
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Handle: RePEc:ubs:wpaper:ubs0605
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  1. Dybvig, Philip H, 1984. " Short Sales Restrictions and Kinks on the Mean Variance Frontier," Journal of Finance, American Finance Association, vol. 39(1), pages 239-44, March.
  2. Gourieroux, C. & Monfort, A., 2005. "The econometrics of efficient portfolios," Journal of Empirical Finance, Elsevier, vol. 12(1), pages 1-41, January.
  3. Pelizzon, Loriana & Weber, Guglielmo, 2008. "Are Household Portfolios Efficient? an Analysis Conditional on Housing," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 43(02), pages 401-431, June.
  4. Basak, Gopal & Jagannathan, Ravi & Sun, Guoqiang, 2002. "A direct test for the mean variance efficiency of a portfolio," Journal of Economic Dynamics and Control, Elsevier, vol. 26(7-8), pages 1195-1215, July.
  5. Das, Sanjiv Ranjan & Uppal, Raman, 2002. "Systemic Risk and International Portfolio Choice," CEPR Discussion Papers 3305, C.E.P.R. Discussion Papers.
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  7. Newey, Whitney K & West, Kenneth D, 1987. "A Simple, Positive Semi-definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix," Econometrica, Econometric Society, vol. 55(3), pages 703-08, May.
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  9. Kenneth D. West & Whitney K. Newey, 1995. "Automatic Lag Selection in Covariance Matrix Estimation," NBER Technical Working Papers 0144, National Bureau of Economic Research, Inc.
  10. Gibbons, Michael R & Ross, Stephen A & Shanken, Jay, 1989. "A Test of the Efficiency of a Given Portfolio," Econometrica, Econometric Society, vol. 57(5), pages 1121-52, September.
  11. Samuelson, William & Zeckhauser, Richard, 1988. " Status Quo Bias in Decision Making," Journal of Risk and Uncertainty, Springer, vol. 1(1), pages 7-59, March.
  12. Gourieroux, C. & Jouneau, F., 1999. "Econometrics of efficient fitted portfolios," Journal of Empirical Finance, Elsevier, vol. 6(1), pages 87-118, January.
  13. Luigi Guiso & Tullio Jappelli, 2000. "Household Portfolios in Italy," CSEF Working Papers 43, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
  14. Tae-Hwan Kim, 2005. "Asymptotic and Bayesian Confidence Intervals for Sharpe-Style Weights," Journal of Financial Econometrics, Society for Financial Econometrics, vol. 3(3), pages 315-343.
  15. Campbell, John Y. & Viceira, Luis M., 2002. "Strategic Asset Allocation: Portfolio Choice for Long-Term Investors," OUP Catalogue, Oxford University Press, number 9780198296942, March.
  16. Alessandro Bucciol, 2003. "Household Portfolios Efficiency in the Presence of Restrictions on Investment Opportunities," Rivista di Politica Economica, SIPI Spa, vol. 93(6), pages 29-67, November-.
  17. Richard H. Thaler & Shlomo Benartzi, 2001. "Naive Diversification Strategies in Defined Contribution Saving Plans," American Economic Review, American Economic Association, vol. 91(1), pages 79-98, March.
  18. Green, R.C. & Hollifield, B., 1990. "When Will Mean-Variance Efficient Portfolios Be Well Diversified?," GSIA Working Papers 1990-12, Carnegie Mellon University, Tepper School of Business.
  19. Almazan, Andres & Brown, Keith C. & Carlson, Murray & Chapman, David A., 2004. "Why constrain your mutual fund manager?," Journal of Financial Economics, Elsevier, vol. 73(2), pages 289-321, August.
  20. Matthew Rabin & Richard H. Thaler, 2001. "Anomalies: Risk Aversion," Journal of Economic Perspectives, American Economic Association, vol. 15(1), pages 219-232, Winter.
  21. Figlewski, Stephen, 1981. "The Informational Effects of Restrictions on Short Sales: Some Empirical Evidence," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 16(04), pages 463-476, November.
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