The Individually Acceptable Loss (IAL)
Posted: 5 Mar 2007
Date Written: February 2007
This paper proposes a new, individual measure of market risk, denoted as the individually acceptable loss (IAL). This measure can be used by portfolio managers in order to better meet the individual profiles of their non-professional clients, including psychological traits. It can be easily assessed from general subjective and objective parameters. We formally define the IAL of loss averse investors, who narrowly frame financial investments, and are sensitive to the past performance of their risky portfolio. This individual risk measure is applied to the classic portfolio optimization framework in order to derive the optimal wealth allocation among different financial assets. Our empirical results suggest that previous optimization relying on a portfolio-exogenous VaR-formulation, underestimates the aversion of individual investors towards financial losses.
Keywords: market risk, prospect theory,loss aversion, capital allocation, Value-at-Risk
JEL Classification: C32, C35, G10
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