Portfolio Selection, Periodic Evaluations and Risk Taking

Alex S. L. Tse () and Harry Zheng ()
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Alex S. L. Tse: Department of Mathematics, University College London, London WC1H 0AY, United Kingdom
Harry Zheng: Department of Mathematics, Imperial College London, London SW7 2AZ, United Kingdom

Operations Research, 2023, vol. 71, issue 6, 2078-2091

Abstract: We present a continuous-time portfolio selection problem faced by an agent with S-shaped preference who maximizes the utilities derived from the portfolio’s periodic performance over an infinite horizon. The periodic reward structure creates subtle incentive distortion. In some cases, local risk aversion is induced, which discourages the agent from risk taking in the extreme bad states of the world. In some other cases, eventual ruin of the portfolio is inevitable, and the agent underinvests in the good states of the world to manipulate the basis of subsequent performance evaluations. We outline several important elements of incentive design to contain the long-term portfolio risk.

Keywords: Financial Engineering; portfolio selection; S-shaped utility; periodic evaluation; agency; incentive (search for similar items in EconPapers)
Date: 2023
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Persistent link: https://EconPapers.repec.org/RePEc:inm:oropre:v:71:y:2023:i:6:p:2078-2091

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