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Optimal asset allocation under linear loss aversion

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  • Fortin, Ines
  • Hlouskova, Jaroslava

Abstract

We study the asset allocation of a linear loss-averse (LA) investor and compare it to the more traditional mean-variance (MV) and conditional value-at-risk (CVaR) investors. First we derive conditions under which the LA problem is equivalent to the MV and CVaR problems and solve analytically the two-asset problem of the LA investor for a risk-free and a risky asset. Then we run simulation experiments to study properties of the optimal LA and MV portfolios under more realistic assumptions. We find that under asymmetric dependence LA portfolios outperform MV portfolios, provided investors are sufficiently loss-averse and dependence is large. Finally, using 13 EU and US assets, we implement the trading strategy of a linear LA investor who reallocates his/her portfolio on a monthly basis. We find that LA portfolios clearly outperform MV and CVaR portfolios and that incorporating a dynamic update of the LA parameters significantly improves the performance of LA portfolios.

Suggested Citation

  • Fortin, Ines & Hlouskova, Jaroslava, 2011. "Optimal asset allocation under linear loss aversion," Journal of Banking & Finance, Elsevier, vol. 35(11), pages 2974-2990, November.
    • Handle: RePEc:eee:jbfina:v:35:y:2011:i:11:p:2974-2990
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    More about this item

    Keywords

    D03 D81 G11 G15 G24 Loss aversion Prospect theory Portfolio optimization MV/CVaR portfolios Copula Investment strategy;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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