Working Paper: CEPR ID: DP17743
Authors: Thomas Gehrig; Leopold Sgner
Abstract: We extend the demand systems approach of Koijen and Yogo (2019) to more general classes of preferences. Specifically we analyse constant absolute and constant relative risk aversion, provide conditions for the existence of equilibrium, and evaluate equilibrium prices at US-data. We find that constant absolute risk aversion works particularly well at moderate levels of risk aversion. In the case of relative risk aversion, optimal interior portfolio solutions may not even exist. In both preference classes especially out-of-sample predictions are rather volatile.In order to improve out-of-sample performance we augment the optimal strategies by a shrinkage device.As a side product we establish that the characteristics-based parametric portfolio approach of Brandt, Santa Clara and Valkanov (2009) can only be justified as optimal investments under exceedingly strong assumptions.In empirical data the shrinkage approach outperformsthe parametric approach and the naive 1/N-strategy over quite a wide range of levels of absolute and relative risk aversion.
Keywords: parametric portfolio approach; expected utility; risk aversion; machine learning
JEL Codes: C51; G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| constant absolute risk aversion (CARA) (D81) | optimal strategies with shrinkage (C73) |
| constant relative risk aversion (CRRA) (D11) | performance of portfolio strategies (G11) |
| risk aversion (D81) | optimal interior portfolio solutions (G11) |
| characteristics-based parametric portfolio approach (G11) | strong assumptions (C51) |
| risk aversion (D81) | performance of strategies (L10) |
| shrinkage approach (C59) | outperforming parametric approach and naive 1/n strategy (C52) |