Maximizing relative wealth using leverage in portfolio management: The role of risk aversion

28 Pages Posted: 30 Jun 2021 Last revised: 14 Dec 2022

Date Written: December 14, 2022

Abstract

Investors can use leverage to increase the returns and profit of an investment. The so-called Kelly criterion is traditionally used to determine the optimal leverage factor for maximizing an investor’s absolute wealth, but it may lead to too risky decisions for rational investors. We develop the Kelly criterion and propose a new risk-adjusted criterion based on quadratic utility for maximizing the investors’ wealth relative to an investment benchmark. Our model enables us to derive the optimal leverage decision for rational investors seeking to maximize relative wealth given investor risk aversion, thereby allowing risk averse investors to benefit from leverage. Our findings demonstrate that it can be rational for risk averse investors to use leverage since leverage enables investors to increase their relative wealth as a proportion of the population total wealth.

Keywords: Leverage, Growth-Risk trade-off, Kelly criterion, Risk Aversion

JEL Classification: G11, G17, G19

Suggested Citation

Lundström Tjurhufvud, Christian and Peltomäki, Jarkko, Maximizing relative wealth using leverage in portfolio management: The role of risk aversion (December 14, 2022). Available at SSRN: https://ssrn.com/abstract=3869589 or http://dx.doi.org/10.2139/ssrn.3869589

Jarkko Peltomäki (Contact Author)

Stockholm University - Stockholm Business School ( email )

Stockholm
Sweden

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