IDEAS home Printed from https://ideas.repec.org/a/gam/jrisks/v12y2024i2p33-d1333422.html
   My bibliography  Save this article

Robust Portfolio Optimization with Environmental, Social, and Corporate Governance Preference

Author

Listed:
  • Marcos Escobar-Anel

    (Department of Statistical and Actuarial Sciences, University of Western Ontario, London, ON N6A 3K7, Canada)

  • Yiyao Jiao

    (Department of Statistical and Actuarial Sciences, University of Western Ontario, London, ON N6A 3K7, Canada)

Abstract

This study addresses the crucial but under-explored topic of ambiguity aversion, i.e., model misspecification, in the area of environmental, social, and corporate governance (ESG) within portfolio decisions. It considers a risk- and ambiguity-averse investor allocating resources to a risk-free asset, a market index, a green stock, and a brown stock. The study employs a robust control approach rooted in relative entropy to account for model misspecification and derive closed-form optimal investment strategies. The key contribution of this study includes demonstrating, using two sets of empirical data on asset returns and ESG ratings, the substantial influence of ambiguity on optimal trading strategies, particularly highlighting the differential effects of market, green, and brown ambiguities. As a by-product of our analytical solutions, the study contrasts ambiguity-averse investors with their non-ambiguity counterparts, revealing more cautious risk exposures with a reduction in short-selling positions for the former. Furthermore, three types of investors who employ popular suboptimal strategies are identified, together with two loss measures used to quantify their performance. The findings reveal that popular strategies, not accounting for ESG and misspecification in the model, could lead to significant financial costs, with the extent of loss varying depending on those two factors: investors’ ambiguity aversion profiles and ESG preferences.

Suggested Citation

  • Marcos Escobar-Anel & Yiyao Jiao, 2024. "Robust Portfolio Optimization with Environmental, Social, and Corporate Governance Preference," Risks, MDPI, vol. 12(2), pages 1-29, February.
    • Handle: RePEc:gam:jrisks:v:12:y:2024:i:2:p:33-:d:1333422
    as

    Download full text from publisher

    File URL: https://www.mdpi.com/2227-9091/12/2/33/pdf
    Download Restriction: no
    File URL: https://www.mdpi.com/2227-9091/12/2/33/
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Christian Flor & Linda Larsen, 2014. "Robust portfolio choice with stochastic interest rates," Annals of Finance, Springer, vol. 10(2), pages 243-265, May.
    2. Escobar-Anel, Marcos, 2022. "Multivariate risk aversion utility, application to ESG investments," The North American Journal of Economics and Finance, Elsevier, vol. 63(C).
    3. Dimmock, Stephen G. & Kouwenberg, Roy & Mitchell, Olivia S. & Peijnenburg, Kim, 2016. "Ambiguity aversion and household portfolio choice puzzles: Empirical evidence," Journal of Financial Economics, Elsevier, vol. 119(3), pages 559-577.
    4. Gasser, Stephan M. & Rammerstorfer, Margarethe & Weinmayer, Karl, 2017. "Markowitz revisited: Social portfolio engineering," European Journal of Operational Research, Elsevier, vol. 258(3), pages 1181-1190.
    5. Kocher, Martin G. & Lahno, Amrei Marie & Trautmann, Stefan T., 2018. "Ambiguity aversion is not universal," European Economic Review, Elsevier, vol. 101(C), pages 268-283.
    6. Pascal J. Maenhout, 2004. "Robust Portfolio Rules and Asset Pricing," The Review of Financial Studies, Society for Financial Studies, vol. 17(4), pages 951-983.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Zeng, Yan & Li, Danping & Chen, Zheng & Yang, Zhou, 2018. "Ambiguity aversion and optimal derivative-based pension investment with stochastic income and volatility," Journal of Economic Dynamics and Control, Elsevier, vol. 88(C), pages 70-103.
    2. Rubtsov, Alexey, 2016. "Model misspecification and pricing of illiquid claims," Finance Research Letters, Elsevier, vol. 18(C), pages 242-249.
    3. Loïc Berger & Louis Eeckhoudt, 2021. "Risk, Ambiguity, and the Value of Diversification," Management Science, INFORMS, vol. 67(3), pages 1639-1647, March.
    4. Sujoy Mukerji & Han N. Ozsoylev & Jean‐Marc Tallon, 2023. "Trading Ambiguity: A Tale Of Two Heterogeneities," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 64(3), pages 1127-1164, August.
    5. Masahide Watanabe & Toshio Fujimi, 2024. "Ambiguity attitudes toward natural and artificial sources in gain and loss domains," Journal of Risk and Uncertainty, Springer, vol. 68(1), pages 51-75, February.
    6. Peter, Richard & Ying, Jie, 2020. "Do you trust your insurer? Ambiguity about contract nonperformance and optimal insurance demand," Journal of Economic Behavior & Organization, Elsevier, vol. 180(C), pages 938-954.
    7. Corgnet, Brice & Hernán-González, Roberto & Kujal, Praveen, 2020. "On booms that never bust: Ambiguity in experimental asset markets with bubbles," Journal of Economic Dynamics and Control, Elsevier, vol. 110(C).
    8. Meyer, Steffen & Uhr, Charline, 2024. "Ambiguity and private investors’ behavior after forced fund liquidations," Journal of Financial Economics, Elsevier, vol. 156(C).
    9. Evren, Özgür, 2019. "Recursive non-expected utility: Connecting ambiguity attitudes to risk preferences and the level of ambiguity," Games and Economic Behavior, Elsevier, vol. 114(C), pages 285-307.
    10. Vitale, Paolo, 2018. "Robust trading for ambiguity-averse insiders," Journal of Banking & Finance, Elsevier, vol. 90(C), pages 113-130.
    11. Rubtsov, Alexey & Xu, Wei & Šević, Aleksandar & Šević, Željko, 2021. "Price of climate risk hedging under uncertainty," Technological Forecasting and Social Change, Elsevier, vol. 165(C).
    12. Loïc Berger & Louis Eeckhoudt, 2020. "Risk, Ambiguity, And The Value Of Diversification," Working Papers hal-02910906, HAL.
    13. Sun, Yuzhe & Wang, Yanjie & Zhang, Shunming & Huang, Helen, 2023. "The impact of ambiguity-loving attitude on market participation and asset pricing," Economic Modelling, Elsevier, vol. 128(C).
    14. Julian Holzermann, 2023. "Optimal Investment with Stochastic Interest Rates and Ambiguity," Papers 2306.13343, arXiv.org, revised Oct 2023.
    15. Ailing Gu & Xinya He & Shumin Chen & Haixiang Yao, 2023. "Optimal Investment-Consumption and Life Insurance Strategy with Mispricing and Model Ambiguity," Methodology and Computing in Applied Probability, Springer, vol. 25(3), pages 1-19, September.
    16. Dariusz Zawisza, 2020. "A note on the worst case approach for a market with a stochastic interest rate," Papers 2001.01998, arXiv.org.
    17. Horváth, Ferenc, 2017. "Essays on robust asset pricing," Other publications TiSEM e54d7b33-1f27-4b0e-9f84-f, Tilburg University, School of Economics and Management.
    18. Panos Xidonas & Ralph Steuer & Christis Hassapis, 2020. "Robust portfolio optimization: a categorized bibliographic review," Annals of Operations Research, Springer, vol. 292(1), pages 533-552, September.
    19. Aggarwal, Divya & Damodaran, Uday, 2020. "Ambiguity attitudes and myopic loss aversion: Experimental evidence using carnival games," Journal of Behavioral and Experimental Finance, Elsevier, vol. 25(C).
    20. Zeng, Yan & Li, Danping & Gu, Ailing, 2016. "Robust equilibrium reinsurance-investment strategy for a mean–variance insurer in a model with jumps," Insurance: Mathematics and Economics, Elsevier, vol. 66(C), pages 138-152.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:gam:jrisks:v:12:y:2024:i:2:p:33-:d:1333422. See general information about how to correct material in RePEc.

    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 CitEc recognized a bibliographic reference but did not link an item in RePEc 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 RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: MDPI Indexing Manager (email available below). General contact details of provider: https://www.mdpi.com .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.