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Time-Varying Risk Aversion and Dynamic Portfolio Allocation

Author

Listed:
  • Haitao Li

    (Cheung Kong Graduate School of Business, Beijing 100738, China)

  • Chongfeng Wu

    (Antai College of Economics and Management, Shanghai Jiao Tong University, Shanghai 200030, China)

  • Chunyang Zhou

    (Antai College of Economics and Management, Shanghai Jiao Tong University, Shanghai 200030, China)

Abstract

We study the implications of time-varying risk aversion for dynamic portfolio allocation under the framework of regime-switching models. In our model, both asset returns and investor risk aversion are regime dependent: In a bull regime, asset return is high, volatility is low, and risk aversion is low, and the opposite happens in a bear regime. We develop an efficient dynamic programming algorithm that overcomes the challenges imposed by regime-dependent preference in obtaining time-consistent portfolio policies. Empirically, we show that CBOE Volatility Index (VIX) is an important predictor of regime shifts and investors with regime-dependent risk aversion achieve better investment performance than those with constant risk aversion.

Suggested Citation

  • Haitao Li & Chongfeng Wu & Chunyang Zhou, 2022. "Time-Varying Risk Aversion and Dynamic Portfolio Allocation," Operations Research, INFORMS, vol. 70(1), pages 23-37, January.
    • Handle: RePEc:inm:oropre:v:70:y:2022:i:1:p:23-37
    DOI: 10.1287/opre.2020.2095
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