Optimal Asset Allocation under Quadratic Loss Aversion

Ines Fortin and Jaroslava Hlouskova
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Ines Fortin: Department of Economics and Finance, Institute for Advanced Studies, Vienna, Austria

No 291, Economics Series from Institute for Advanced Studies

Abstract: We study the asset allocation of a quadratic loss-averse (QLA) investor and derive conditions under which the QLA problem is equivalent to the mean-variance (MV) and conditional value-at-risk (CVaR) problems. Then we solve analytically the two-asset problem of the QLA investor for a risk-free and a risky asset. We find that the optimal QLA investment in the risky asset is finite, strictly positive and is minimal with respect to the reference point for a value strictly larger than the risk-free rate. Finally, we implement the trading strategy of a QLA investor who reallocates her portfolio on a monthly basis using 13 EU and US assets. We find that QLA portfolios (mostly) outperform MV and CVaR portfolios and that incorporating a conservative dynamic update of the QLA parameters improves the performance of QLA portfolios. Compared with linear loss-averse portfolios, QLA portfolios display significantly less risk but they also yield lower returns.

Keywords: Quadratic loss aversion; prospect theory; portfolio optimization; MV and CVaR portfolios; investment strategy (search for similar items in EconPapers)
JEL-codes: D03 D81 G11 G15 G24 (search for similar items in EconPapers)
Pages: 44 pages
Date: 2012-09
New Economics Papers: this item is included in nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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https://irihs.ihs.ac.at/id/eprint/2161 First version, 2012 (application/pdf)

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