Long-Term Dynamic Asset Allocation Under Asymmetric Risk Preferences

Abstract

In this paper, we examine the impact of return predictability and parameter uncertainty on long-term portfolio allocations when investors treat their expected gains and losses differently. Allowing for different return generating systems, we examine the way portfolio allocation to the risky asset evolves over the course of the investment horizon in the presence of asymmetric responses to risk (e.g., gains vs losses). We find persisting horizon effects, with stocks appearing progressively more attractive at longer horizons as opposed to shorter ones. The role of parameter uncertainty appears to be prominent in the portfolio choice problem. Accounting for this results in both significantly lowering the exposure to the risky asset and dampening the horizon effects driven by return predictability. An equally important aspect of this study relates to detecting a level of disappointment aversion below which it is optimal for investors to hold zero units of a risky asset. In this regard, our decision making framework and analysis have implications for the nonparticipation puzzle in stock markets.

Keywords: Decision analysis, Asset Allocation, Asymmetric Risk Preferences, Parameter uncertainty, Simulation Study

JEL Classification: G40, C61, G11