Time consistent behavioral portfolio policy for dynamic mean–variance formulation

Xiangyu Cui, Xun Li, Duan Li and Yun Shi ()
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Xiangyu Cui: Shanghai University of Finance and Economics
Xun Li: The Hong Kong Polytechnic University
Duan Li: The Chinese University of Hong Kong
Yun Shi: Shanghai University

Journal of the Operational Research Society, 2017, vol. 68, issue 12, 1647-1660

Abstract: Abstract When one considers an optimal portfolio policy under a mean-risk formulation, it is essential to correctly model investors’ risk aversion which may be time variant or even state dependent. In this paper, we propose a behavioral risk aversion model, in which risk aversion is a piecewise linear function of the current excess wealth level with a reference point at the discounted investment target (either surplus or shortage), to reflect a behavioral pattern with both house money and break-even effects. Due to the time inconsistency of the resulting multi-period mean–variance model with adaptive risk aversion, we investigate the time consistent behavioral portfolio policy by solving a nested mean–variance game formulation. We derive a semi-analytical time consistent behavioral portfolio policy which takes a piecewise linear feedback form of the current excess wealth level with respect to the discounted investment target. Finally, we extend the above results to time consistent behavioral portfolio selection for dynamic mean–variance formulation with a cone constraint.

Keywords: investment analysis; state-dependent risk aversion; dynamic mean–variance formulation; time consistency; behavioral portfolio policy (search for similar items in EconPapers)
Date: 2017
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Citations: View citations in EconPapers (5)

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DOI: 10.1057/s41274-017-0179-6

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