Adaptive Portfolio Allocation with Options

We conducted a laboratory experiment of repeated portfolio allocation choice between a bond, a stock, and a put option on the stock. The study involves two conditions: a full hedging possibility and a partial hedging possibility. Surprisingly, participants were able to converge to the mean-variance frontier in the environment with partial hedging possibilities, but were unable to do so in the full hedging condition. This suggests that subjects may not be cognizant of the mean-variance frontier. If subjects begin away from the frontier and have to adjust toward it, incentives off the frontier are critical. Simulations of adaptive dynamic models confirm this assertion. The study provides insight into the adaptive behavior of investors in the presence of hedging possibilities and implications for efficient investment strategies.