Asymmetric Nonlinear Return Extrapolation and Optimal Portfolio Choice under Stochastic Volatility

Dong Yan, Wenrui Ye, Zhiyue Zong and Wenting Chen

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Abstract: We extend the return extrapolation framework of Atmaz (2022) to incorporate two behaviorally realistic features absent from the linear benchmark: saturation in belief updating and asymmetry between gains and losses. We introduce a smooth, nonlinear, asymmetric extrapolation function and characterize the optimal portfolio of a CRRA investor under Heston (1993) stochastic volatility as the sum of a sentiment-distorted myopic demand, a variance hedging demand, and a sentiment hedging demand. The resulting semilinear Hamilton-Jacobi-Bellman equation is solved by two independent numerical methods, a finite-difference ADI scheme with time-step policy iteration and a deep learning-driven iterative scheme. The model generates four investor-level behavioral anomalies: asymmetric responses to gains and losses, attenuated reactions at extremes, excess trading volume, and welfare loss rising with the strength of extrapolation, each of which maps onto documented empirical patterns. Its central finding is that saturation acts as an endogenous correction mechanism: at the same local slope at the origin, the asymmetric nonlinear extrapolator carries a smaller welfare loss than a linear one.

Date: 2026-06
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