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The impact of fat tailed returns on asset allocation

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  • Yesim Tokat
  • Eduardo S. Schwartz

Abstract

This paper analyzes the asset allocation problem of an investor who can invest in equity and cash when there is time variation in expected returns on the equity. The solution methodology is multistage stochastic asset allocation problem with decision rules. The uncertainty is modeled using economic scenarios with Gaussian and stable Paretian non-Gaussian innovations. The optimal allocations under these alternative hypothesis are compared. Our computational results suggest that asset allocation may be up to 20% different depending on the utility function and the risk aversion level of the investor. Certainty equivalent return can be increased up to .13% and utility can be improved up to .72% by switching to the stable Paretian model. Copyright Springer-Verlag Berlin Heidelberg 2002

Suggested Citation

  • Yesim Tokat & Eduardo S. Schwartz, 2002. "The impact of fat tailed returns on asset allocation," Mathematical Methods of Operations Research, Springer;Gesellschaft für Operations Research (GOR);Nederlands Genootschap voor Besliskunde (NGB), vol. 55(2), pages 165-185, May.
    • Handle: RePEc:spr:mathme:v:55:y:2002:i:2:p:165-185
    DOI: 10.1007/s001860200183
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    Cited by:

    1. Alvaro Cartea & Sam Howison, 2004. "Option Pricing with Levy-Stable Processes," OFRC Working Papers Series 2004mf01, Oxford Financial Research Centre.
    2. Alvaro Cartea & Sam Howison, 2009. "Option pricing with Levy-Stable processes generated by Levy-Stable integrated variance," Quantitative Finance, Taylor & Francis Journals, vol. 9(4), pages 397-409.
    3. Rosella Giacometti & Domenico Mignacca, 2010. "Using the Black and Litterman framework for stress test analysis in asset management," Journal of Asset Management, Palgrave Macmillan, vol. 11(4), pages 286-297, October.

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