Skew and Trend Aversion

Abstract

Despite evidence of the benefits to portfolio Sharpe ratio and variance, actual investor allocations to Trend Following strategies are typically 5% or less. Why is there such a significant discrepancy between the optimal allocation and actual allocation to Trend? We investigate known behavioral biases as a potential reason. While decision makers have other reasons to exclude Trend Following from their portfolios, in this paper, we explore loss aversion, recency bias, and the ambiguity effect as they pertain to Trend Following, and we call the combination of the three Trend Aversion. We quantify Trend Aversion and show that these biases are a viable explanation for suboptimal allocations to Trend. We demonstrate a direct connection between quantifications of known behavioral biases and current suboptimal allocations to Trend Following. Recognition of these relationships will help highlight the pitfalls of behavioral biases.

Keywords: behavioral biases, loss aversion, recency bias, skew, trend following, portfolio optimization