Time-Varying Risk Aversion and Dynamic Portfolio Allocation

Haitao Li (), Chongfeng Wu () and Chunyang Zhou ()
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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

Operations Research, 2022, vol. 70, issue 1, 23-37

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.

Keywords: dynamic portfolio allocation; regime-dependent risk aversion; regime-switching model; Financial Engineering (search for similar items in EconPapers)
Date: 2022
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