Individual risk attitudes and the composition of financial portfolios: Evidence from German household portfolios

This paper explores the relationship between the self-declared risk aversion of private investors and their propensity to hold incomplete portfolios of financial assets. The analysis is based on household survey data from the German Socioeconomic Panel (SOEP) that provides a reliable measure of individual attitudes toward financial risk. Our findings suggest that more risk averse households tend to hold incomplete portfolios consisting mainly of a few risk-free assets. We also find that the propensity to acquire additional assets is highly dependent on whether liquidity and safety needs are met.     

Price impact,strategic interaction and portfolio choice

This paper studies the portfolio choice of two large investors who act strategically because their trading affects interest rates. Each investor chooses her optimal portfolio conditional on the portfolio of the opponent. Equilibrium portfolios and their performance depend on the investor’s characteristics (risk aversion and return impact) and on the characteristics of the opponent (risk aversion and return impact). Depending on the interplay among these characteristics, strategic interaction can (i) increase or decrease risk taking incentives, as compared to the Merton-style portfolio, (ii) induce the more risk-averse investor to invest relatively more in the risky asset and (iii) change the role of inflation-linked bonds from hedging instrument to borrowing opportunity.     

The Economic Determinants of the Home Country Bias in Investors' Portfolios: A Survey

In this article, we survey the international portfolio choice literature to investigate why investors choose to bias their portfolios towards domestic equity, even though there are significant gains to diversifying internationally. We focus on three potential explanations. First, we consider if the high proportion of domestic assets in investors' portfolios can be explained by their desire to hedge home inflation. While the models of Krugman (1981), Sercu (1980), Adler and Dumas (1983), and Stulz (1981a, 1983) suggest that this is the case, the model in Uppal (1993) shows that this is true only when relative risk aversion is less than one. Second, we consider the prevailing institutional barriers to foreign investment to see if they are sufficiently large to explain the bias observed in investors' portfolios. Halliday (1989) reports that there are few constraints on investing in foreign stock markets. This is especially true when investing in the markets of developed countries. Even when restrictions exist, they are usually not binding. Third, we consider the models of Black (1974) and Stulz (1981b) to see if transactions costs for investing abroad and taxes on income from foreign assets can explain the home equity bias. Cooper and Kaplanis (1986, 1991) and French and Porterba (1991) estimate that the taxes required to explain the observed bias are much larger than those investors actually face. We conclude that it is unlikely that these three factors are significant enough to explain the degree of the bias in portfolios that is observed empirically.     

Pricing the hedging factor in the cross-section of stock returns

We investigate the role of investors’ net hedging strategy (factor) in predicting stock returns and pricing the cross-section of individual stocks and equity portfolios. We estimate stock exposure to changes in the hedging factor and show that the hedging premium is driven by outperformance of stocks with large positive net hedging betas, which explains their higher average returns. We find the positive hedging premium indicates risk-averse investors demand extra compensation to hold stocks with higher equity risk premiums, and they are themselves willing to pay higher prices for stocks with positive hedging betas.     

Heterogeneous ambiguity attitudes: a field experiment among small-scale stock investors in China

We conducted quasi-field experiments in Chinese brokerage houses to investigate how investors react to ambiguity relative to quantifiable risks and the degree of heterogeneity in these reactions. Our experiment consists of three sections; a background survey; individual self-reports of emotional states; and a series of individual portfolio choice questions involving ambiguous assets and assets with a known probability of success. We calculate an index of ambiguity aversion that controls for risk aversion through a series of simple choices and demonstrate its outside validity. We find a significant degree of heterogeneity in ambiguity attitudes and discuss some demographic or emotional factors that might contribute to this heterogeneity. We also discuss the correlation between ambiguity attitudes and risk attitudes. By conducting these experiments in China, we were able to measure the degree of ambiguity aversion among a sample of experienced and accessible investors who face ambiguous decisions on a daily basis.     

A model of international asset pricing under imperfect commodity arbitrage

This paper examines the effect of imperfect international commodity arbitrage (i.e., violation of the law of one price), modeled as the existence of non-traded goods, on the structure of purchasing power risk, optimal portfolio rules of the risk-averse investors and the equilibrium yield relationship among assets. The major results of the paper include: (i) There are two separate sources of purchasing power risk, i.e., relative price risk and inflation risk; relative price risk is specific to the country in which the investor resides. (ii) In a world of n countries, investors may hold n + 1 hedge portfolios as vehicles to hedge against purchasing power risk; facing different relative prices, investors residing in different countries display divergent portfolio behavior. (iii) In equilibrium, investors are compensated in terms of excess return for bearing not only the systematic world market risk but also the systematic inflation and relative price risks.     

Cross-sectional implications of dynamic asset pricing with stochastic volatility and ambiguity aversion

Building on recent research that highlights the importance of macroeconomic volatility and ambiguity aversion in explaining the dynamics of stock returns, in this paper we propose a dynamic asset pricing model that simultaneously accounts for stochastic macroeconomic volatility and ambiguity, assuming that investors deal with uncertainty about the mechanics of macroeconomic fluctuations using first-release consumption and revisions to aggregate consumption on vintage data. Our results show that the proposed model captures a large fraction of the cross-sectional variation of excess returns for a wide range of market anomaly portfolios. Furthermore, while the price of risk for ambiguity is positive and significant for the vast majority of assets under study, macroeconomic volatility yields ambiguous outcomes, although it significantly increases the explanatory power of the model for specific assets. Our results suggest that macroeconomic volatility and ambiguity complement each other in explaining the cross-sectional behavior of stock returns.     

Attitude towards risk,uncertainty, and fixed investment

We explore the relevance of the risk attitude of managers to the investment-uncertainty relation. Higher moments of the distribution of net profits are used to measure the risk premium of the firm, from which we derive a proxy for the risk aversion of managers. Using an unbalanced panel of Dutch listed firms, we find that in general a low degree of risk aversion coincides with a positive impact of demand uncertainty on investment. More specifically, we find that risk-averse firms respond to demand uncertainty by cutting investment, while the investment undertaken by risk-taking firms responds to demand uncertainty positively.     

Measuring the economic significance of mean-variance spanning

This paper investigates the economic significance of mean-variance spanning tests using three classical statistical tests in a unified framework. I show how to compute confidence intervals about the Sharpe ratios of tangent portfolios, the variance of return of minimum variance portfolios, as well as the certainty equivalent utility gains. I apply this statistical framework to the question of whether US investors should diversify internationally. The analysis suggests that a strong statistical rejection of the hypothesis that there is no improvement in the minimum variance portfolio’s standard deviation of return does not imply that there are no significant economic benefits to be made in terms of a substantial risk reduction. These results have important implications for empirical tests of mean-variance spanning as well as empirical assets pricing tests and minimum variance bounds on stochastic discount factors.     

Hedge funds in portfolios of risk-averse investors

We find that adding a hedge fund to an optimally weighted portfolio of stocks and T-bills generally increases the utility of an investor. From a sample of hedge funds with returns from 1996 to 2005, the certainty equivalent was an average of five basis points (monthly) higher with a ten percent allocation into a hedge fund. Funds from different style categories require different allocations into the stock market, but nearly all funds improved performance. Contrary to popular opinion, we find that highly risk-averse investors gain even more than less risk-averse investors by adding a hedge fund into their portfolio.     

The behavior of MENA oil and non-oil producing countries in international portfolio optimization

It is well documented in developed economies that portfolio investment across national borders brings benefits of increasing returns and/or reducing risk. Dividing MENA stock markets into two main groups (oil producing and non-oil producing countries), this study examines the potential role of each group in providing diversification benefits for international investors. In addition, the behavior of the long and the short-run Efficient Frontiers (EFs) constructed by each of the sub-groups and the combined MENA markets is explored. Multi-objective international portfolio models are proposed under Mean-Variance and Mean-Lower Partial Moment frameworks, and the Multiple Fitness Function Genetic Algorithm (MFFGA) is used to find the EFs of optimal portfolios. The findings indicate that the stock markets of oil producing countries can be considered as a potential avenue for international portfolio diversification for investors not only from the same countries but also from the other MENA markets. It was also found that international portfolios constructed from the combination of MENA equity markets are more stable compared to the portfolios of sub-group markets. Further, the findings indicate that the behavior of short-term EFs in the MENA region cannot be predicted by the behavior of long-term EFs.     

Assessing and valuing the nonlinear structure of hedge fund returns

Several studies have put forward that hedge fund returns exhibit a nonlinear relationship with equity market returns, captured either through constructed portfolios of traded options or piece‐wise linear regressions. This paper provides a statistical methodology to unveil such nonlinear features with respect to returns on benchmark risk portfolios. We estimate a portfolio of options that best approximates the returns of a given hedge fund, account for this search in the statistical testing of the nonlinearity, and provide a reliable test for a positive valuation of the fund. We find that not all fund categories exhibit significant nonlinearities, and that only a few strategies provide significant value to investors. Our methodology helps identify individual funds that provide value in an otherwise poorly performing category. Copyright © 2010 John Wiley & Sons, Ltd.     

Diversified behavioral portfolio as an alternative to Modern Portfolio Theory

The traditional mean–variance approach has been complemented by alternative theories that use risk measures different from standard deviation of returns or involve additional distributional features of returns like skewness and kurtosis. We propose a portfolio choice model that combines different distributional characteristics of the returns in the decision-making making process, considering preferences of investors which are modeled as non-statistical uncertainties of investors using fuzzy theory. We use 20 stocks of the S&P500 from January 2013 to December 2017. We assess the obtained portfolios’ performance, and the diversified behavioral portfolios outperform than the mean–variance portfolio. This methodological proposal can be seen as a strong managerial tool to make investment portfolio decisions.     

Selecting a discrete portfolio

We study the problem of selecting an optimal portfolio out of a finite set of available assets. Assets are characterized by their expected returns and the covariance matrix, and investors are assumed to have a mean–variance utility, that is, their utility function is linear in the mean and variance of the portfolio they hold.When assets are negatively correlated, or even when a slightly more general condition is satisfied, we provide an algorithm for selecting an optimal portfolio. We illustrate the usefulness of this algorithm by some comparative statics result. When assets can be positively correlated, we deliver a negative result regarding the existence of useful algorithms for selecting an optimal portfolio.     

Value investing versus other investment strategies: A volatility spillover approach and portfolio hedging strategies for investors

Motivated by the incessant demand for portfolio diversification, this study examines the connectedness between value and diverse types of stocks (growth, momentum, ESG, high beta, classic S&P 500, volatility). The applied methodology encompasses the time-varying parameter vector autoregressive (TVP-VAR) extension of the Diebold and Yilmaz (2012) framework for the period from 03/31/2011 to 03/31/2021. Results show moderate volatility transmissions among the sampled assets, which tend to escalate during periods of turmoil, such as the European Sovereign Debt Crisis, the plunge in oil prices and the COVID-19 outbreak. Growth and ESG stocks play an indispensable part in the transmission mechanism. Moreover, we investigate the hedging ability of value stocks within a portfolio containing other stocks, by estimating hedge ratios and optimal weights with the usage of conditional variance estimates (DCC-GARCH). The empirical findings reveal that value stocks can adequately hedge against the risk deriving from the volatility of the remaining investment instruments, especially in the case of high beta and volatility stocks. Thus, this analysis provides portfolio managers and investors with valuable insights in order for them to hedge their stock portfolios effectively.     

Optimal full-hedging under state-dependent preferences

This paper examines the hedging behavior of a risk-averse individual who faces uncertainty in spot-market prices and has a state-dependent utility function. The model demonstrates how risk aversion, state-dependency of preferences, and dependence structure of spot-market prices and states of nature jointly determine the individual’s optimal hedge position. We stipulate two sets of necessary and sufficient conditions, one on the utility function and the other on the dependence structure of spot-market prices and states of nature, which yield the celebrated full-hedging theorem originally derived under state-independent preferences.     

Risk Preferences and Asset Ownership: Integrating Prospect Theory and Transaction Cost Economics

We integrate prospect theory into the discussion of Transaction Cost Economics (TCE) to illustrate how risk aversion may affect integration decisions. In particular, we argue that risk aversion creates incentives to acquire assets in situations where neither opportunism nor transaction‐specific investments are present, provided the assets in question can change in value unpredictably during their use. Our theory illustrates that risk aversion could connect opportunism, asset specificity, and uncertainty with integration decisions in the presence of incomplete contracts. Our theory complements and extends TCE by showing the role of risk aversion in integration decisions under bounded rationality and contract incompleteness. Copyright © 2015 John Wiley & Sons, Ltd.     

Liquidity,bank runs,and fire sales under local thinking

We examine the implications on banking crises when markets are populated by agents that neglect tail risks and form expectations conditioned on a favorable subset of possible states of the economy. We find that optimal bank liquidity is lower than would be the case under rational expectations, and, consequently, the banking system is more vulnerable to adverse shocks, which lead to bank runs. Asset pledgeability of surviving banks is also affected so that their capacity to raise external funds for purchasing assets of distressed banks is weakened. Further, we examine the case when asset returns are correlated through securitization. In this case adverse shocks are felt uniformly across the banking sector and banks that survive with the help of a public liquidity backstop will become risk-averse and reluctant to purchase distressed assets. Finally, we explore a government funded asset purchase program, that is implemented with an asset price target.     

Are the interdependence characteristics of the US and Canadian energy equity sectors nonlinear and asymmetric?

Nonlinear, symmetric, and asymmetric dependence characteristics in energy equity sectors matter to portfolio investors and risk managers because of the risks and diversification opportunities they entail. Specifically, nonlinear dependence dynamics between assets are harder to predict, monitor, and manage, and can make investment positions go wrong unexpectedly. In this paper, we investigate whether the dependence dynamics of US and Canadian large-capitalized energy equity portfolios are nonlinear, symmetric, or asymmetric. We draw our results by implementing a robust copula approach based on time-varying parameter copulas and vine copula methods. Both time varying parameter and vine-copula methods indicate that the Canadian energy sector portfolio is driven by nonlinear negative tail asymmetric dependence during the global financial crisis and when the full sample period is employed. On the other hand, it displays nonlinear symmetric dependence during the oil price crisis, implying the need for close monitoring and rebalancing and a more continuous assessment of long investment positions. The US energy sector portfolio is driven by positive tail asymmetric dependence, and by symmetric dependence dynamics during crisis and non-crisis periods.     

Relative risk aversion and the transmission of financial crises

We study how investor behavior affects the transmission of financial crises. If investors exhibit decreasing relative risk aversion, then negative wealth shocks increase the risk premium required to hold risky assets. We integrate this into a second generation model of currency crises which allows for contagion through changes in fundamentals. Investor behavior can be a transmission channel of financial crises, as changes in risk premia increase the coverage ratio and makes the defense of a peg less attractive for the policy maker. The feedback effect of the risk premia on the probability of devaluation also makes multiple equilibria more likely. The possible stabilization effects of capital controls and a Tobin tax on the international transmission of financial crises are also studied.