A Discretionary Wealth Approach to Investment Policy
Despite portfolio construction based on expected utility theory and Markowitz mean-variance optimization having been the foundation of financial economic theory for more than 50 years, its practical application by financial advisors has been limited. Particularly troubling are the lack of a normative risk-aversion parameter customized to individual investor circumstances and the need for extensive constraints to produce practically acceptable results. We propose a comprehensive conceptual framework for better investment policy. To begin, we develop investor circumstance-contingent risk aversion for use in portfolio construction, taking into account higher moments of return only as needed. We recursively maximize expected logarithmic return on what we define as "discretionary wealth" to generate many-period maximization of median wealth without violating interim shortfall points. Then we extend this basic framework based on point estimates to fully Bayesian logic. This offers not only improved decision inputs but the advantage of deriving the probability distribution of the objective as a function of portfolio weights before selecting the best portfolio. Implications are discussed for a wide array of practical issues: investor leverage, longevity risk, higher return moments, dynamic hedging, life-cycle investing, performance measures, and robust portfolio construction. Hypotheses for implied market structure and pricing are also generated.
|Date of creation:||01 Mar 2009|
|Date of revision:|
|Contact details of provider:|| Web page: http://icf.som.yale.edu/|
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Kan, Raymond & Zhou, Guofu, 2007. "Optimal Portfolio Choice with Parameter Uncertainty," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 42(03), pages 621-656, September.
- Hakansson, Nils H., 1971. "Capital Growth and the Mean-Variance Approach to Portfolio Selection," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 6(01), pages 517-557, January.
- Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-65, June.
- Grossman, Sanford J & Laroque, Guy, 1990.
"Asset Pricing and Optimal Portfolio Choice in the Presence of Illiquid Durable Consumption Goods,"
Econometric Society, vol. 58(1), pages 25-51, January.
- Sanford J. Grossman & Guy Laroque, 1987. "Asset Pricing and Optimal Portfolio Choice in the Presence of Illiquid Durable Consumption Goods," NBER Working Papers 2369, National Bureau of Economic Research, Inc.
- Sanford J Grossman & Guy Laroque, 2003. "Asset Pricing and Optimal Portfolio Choice in the Presence of Illiquid Durable Consumption Goods," Levine's Working Paper Archive 618897000000000803, David K. Levine.
- Jorion, Philippe, 1986. "Bayes-Stein Estimation for Portfolio Analysis," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 21(03), pages 279-292, September.
- Stutzer, Michael, 2003. "Portfolio choice with endogenous utility: a large deviations approach," Journal of Econometrics, Elsevier, vol. 116(1-2), pages 365-386.
- Merton, Robert C. & Samuelson, Paul A., 1974. "Fallacy of the log-normal approximation to optimal portfolio decision-making over many periods," Journal of Financial Economics, Elsevier, vol. 1(1), pages 67-94, May.
- Markowitz, Harry M & Perold, Andre F, 1981. "Portfolio Analysis with Factors and Scenarios," Journal of Finance, American Finance Association, vol. 36(4), pages 871-77, September.
- Eugene F. Fama, 1968. "Risk, Return And Equilibrium: Some Clarifying Comments," Journal of Finance, American Finance Association, vol. 23(1), pages 29-40, 03.
- John Y. Campbell, 2006.
Journal of Finance,
American Finance Association, vol. 61(4), pages 1553-1604, 08.
- Markowitz, Harry M, 1983. " Nonnegative or Not Nonnegative: A Question about CAPMs," Journal of Finance, American Finance Association, vol. 38(2), pages 283-95, May.
- Hakansson, Nils H., 1974. "Comment on Merton and Samuelson," Journal of Financial Economics, Elsevier, vol. 1(1), pages 95-95, May.
- Dybvig, Philip H, 1995. "Dusenberry's Ratcheting of Consumption: Optimal Dynamic Consumption and Investment Given Intolerance for Any Decline in Standard of Living," Review of Economic Studies, Wiley Blackwell, vol. 62(2), pages 287-313, April.
- Black, Fischer & Perold, AndreF., 1992. "Theory of constant proportion portfolio insurance," Journal of Economic Dynamics and Control, Elsevier, vol. 16(3-4), pages 403-426.
- Greyserman, Alex & Jones, Douglas H. & Strawderman, William E., 2006. "Portfolio selection using hierarchical Bayesian analysis and MCMC methods," Journal of Banking & Finance, Elsevier, vol. 30(2), pages 669-678, February.
- Rubinstein, Mark, 1976. "The Strong Case for the Generalized Logarithmic Utility Model as the Premier Model of Financial Markets," Journal of Finance, American Finance Association, vol. 31(2), pages 551-71, May.
- Markowitz, Harry M, 1976. "Investment for the Long Run: New Evidence for an Old Rule," Journal of Finance, American Finance Association, vol. 31(5), pages 1273-86, December.
- Levy, H & Markowtiz, H M, 1979. "Approximating Expected Utility by a Function of Mean and Variance," American Economic Review, American Economic Association, vol. 69(3), pages 308-17, June.
- Campbell R. Harvey & Akhtar Siddique, 2000. "Conditional Skewness in Asset Pricing Tests," Journal of Finance, American Finance Association, vol. 55(3), pages 1263-1295, 06.
- Ledoit, Olivier & Wolf, Michael, 2004. "A well-conditioned estimator for large-dimensional covariance matrices," Journal of Multivariate Analysis, Elsevier, vol. 88(2), pages 365-411, February.
When requesting a correction, please mention this item's handle: RePEc:ysm:somwrk:amz2434. See general information about how to correct material in RePEc.
If references are entirely missing, you can add them using this form.