Asymmetries and Portfolio Choice
51 Pages Posted: 13 May 2015 Last revised: 20 Jul 2016
Date Written: July 19, 2016
We examine the portfolio choice of an investor with generalized disappointment-aversion preferences who faces log 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. In empirical applications, we find that disappointment aversion is associated with much larger asymmetry aversion than are standard preferences. Our model explains patterns in popular portfolio advice across both risk appetites and investment horizons.
Keywords: Asset allocation, disappointment aversion, downside risk, loss aversion, reference-dependent preferences, skewness.
JEL Classification: G11
Suggested Citation: Suggested Citation