Affective Portfolio Analysis: Risk, Ambiguity and (IR)Rationality
57 Pages Posted: 25 Sep 2019
Date Written: September 24, 2019
Ambiguous assets are characterized as assets where objective and subjective probabilities of tomorrow’s asset-returns are ill-deﬁned or may not exist, e.g., bitcoin, volatility indices or any IPO. Investors may choose to diversify their portfolios of ﬁat money, stocks and bonds by investing in ambiguous assets, a fourth asset class, to hedge the uncertainties of future returns that are not risks.
(IR)rational probabilities are computable alternative descriptions of the distribution of returns for ambiguous assets. (IR)rational probabilities can be used to deﬁne an investor’s (IR)rational expected utility function in the class of non-expected utilities. Investment advisors use revealed preference analysis to elicit the investor’s composite preferences for risk tolerance, ambiguity aversion and optimism.
Investors rationalize (IR)rational expected utilities over portfolios of ﬁat money, stocks, bonds and ambiguous assets by choosing their optimal portfolio investments with (IR)rational expected utilities. Subsequently, investors can hedge future losses of their optimal portfolios by purchasing minimum-cost portfolio insurance.
Keywords: Behavioral Finance, Prospect Theory, Afriat Inequalities
JEL Classification: B31, C91, D9
Suggested Citation: Suggested Citation