Working Paper: CEPR ID: DP10706
Authors: Magnus Dahlquist; Adam Farago; Romo Tdongap
Abstract: We examine the portfolio choice of an investor with generalized disappointment aversion preferences who faces returns described by a normal-exponential model. We derive a three-fund separation strategy: the investor allocates wealth to a risk-free asset, a standard mean-variance efficient fund, and an additional fund reflecting return asymmetries. The optimal portfolio is characterized by the investor's endogenous effective risk aversion and implicit asymmetry aversion. We find that disappointment aversion is associated with much larger asymmetry aversion than are standard preferences. Our model explains patterns in popular portfolio advice and provides a reason for shifting from bonds to stocks as the investment horizon increases.
Keywords: asset allocation; downside risk
JEL Codes: G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| disappointment aversion (D81) | greater asymmetry aversion (D81) |
| greater asymmetry aversion (D81) | allocate larger portion of wealth to asymmetry-variance fund (G11) |
| investment horizon increases (D15) | asset returns become more symmetric (G19) |
| asset returns become more symmetric (G19) | shift in portfolio allocations from bonds to stocks (G11) |
| disappointment aversion (D81) | higher fraction of wealth in asymmetry-variance fund (G11) |
| higher fraction of wealth in asymmetry-variance fund (G11) | larger bond-stock allocation ratios (G12) |
| disappointment aversion (D81) | differences in optimal portfolio choices (G11) |