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Sensitivity of cautious-relaxed investment policies to target variation

  • Foster, Jarred
  • Krawczyk, Jacek B

This study builds on recent findings that target-based utility measures, used in the dynamic portfolio optimisation, deliver investment policies that can generate leftskewed payoff distributions. These policies can lead to small probabilities of low payoffs. This is in contrast to the classical portfolio optimisation strategies that commonly deliver right-skewed payoff distributions, which imply a high probability of losses. The left-skewed payoff distributions can be obtained when a “cautious-relaxed” investment policy is applied in portfolio management. Such a policy will be adopted by investors who are both cautious in seeking a payoff meeting a certain target, but relaxed toward the possibility of exceeding it. We use computational methods to analyse the effects of varying the target on the payoff distribution and also examine how the fund manager’s explicit preferences, when they differ from the investor’s, can impact the distribution. We found that increasing the target causes the distribution to become less left skewed. Lowering the target slightly, keeps the left-skewed payoff distribution albeit the mode diminishes. Decreasing the target substantially so it is below the safe investment payoff, changes the skew. Investor’s payoff will not suffer even if the actual fund manager allows for their own utility in the optimisation problem.

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File URL: http://researcharchive.vuw.ac.nz/handle/10063/2972
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Paper provided by Victoria University of Wellington, School of Economics and Finance in its series Working Paper Series with number 2972.

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Date of creation: 2013
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Handle: RePEc:vuw:vuwecf:2972
Contact details of provider: Postal: Alice Fong, Administrator, School of Economics and Finance, Victoria Business School, Victoria University of Wellington, PO Box 600 Wellington, New Zealand
Phone: +64 (4) 463-5353
Fax: +64 (4) 463-5014
Web page: http://www.victoria.ac.nz/sef
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  1. Samuelson, Paul A, 1969. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 239-46, August.
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  11. Azzato, Jeffrey & Krawczyk, Jacek, 2006. "SOCSol4L An improved MATLAB package for approximating the solution to a continuous-time stochastic optimal control problem," MPRA Paper 1179, University Library of Munich, Germany.
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  15. 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.
  16. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, 03.
  17. 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.
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