Asset Allocation for Individual (And Other?) Investors
Quant Finance Wednesday Wisdom - literature focused on asset allocation for individual portfolios based on risk preferences using a tool called the gain-pain index (GPI)
Welcome, friends,
It’s Wednesday. Which means, we’re taking a literature focus today. The idea is that we’ll be diving into key literature, academic insights, or thought-provoking articles in Quantitative Finance. This involves exploring influential papers, books, and publications in the field. Sometimes, this will also mean concentrating on the narrative and storytelling aspect of finance, analyzing case studies, and historical financial events through literature.
Asset Allocation for Individuals Portfolios
It’s starting to be the start of the tax season here in the US, which means people are starting to receive tax forms from their various US Government retirement accounts like 401(k)’s (tax-advantaged retirement account offered by many employers).
Looking at my personal tax forms, reminded me of the paper “The Gain-Pain Index: Asset Allocation for Individual (And Other?) Investors” by Javier Estrada from the IESE Business School (Instituto de Estudios Superiores de la Empresa, the graduate business school of the University of Navarra, Spain).
This is because when I’ve chatted with retirement financial advisors before, they sent me a questionnaire to fill out to help me think through how to setup/modify/think about asset allocation in my 401(k). These questionnaires were never straightforward and included somewhat vague questions about what my goals were and how I thought about risk.
What this paper covers
In today’s paper, Estrada looks at
the case that the better investors understand their portfolios, the more likely they are to stick with them, as opposed to bailing out at the first sign of trouble. For this reason, the tool that advisors use to make an asset allocation recommendation to individual investors should ideally help clients understand the relevant trade-offs involved. That is, precisely, the ultimate purpose of the methodology introduced in this article
Estrada then develops a tool to help investors
The tool proposed here, the gain-pain index (GPI), highlights the gain and pain expected from the asset allocations considered, the latter accounting for an investor’s risk tolerance. In the model the gain is given by the return expected from each portfolio and the pain by three sources of risk, namely, volatility, the probability of suffering a loss, and the magnitude of the loss, the latter two combined into one variable, the expected loss.
Lastly, Estrada uses the tool
The tool proposed here is first illustrated with an example where all the relevant variables are calculated and the relevant trade-offs are discussed. Then it is used to determine optimal asset allocations for the U.S., for several portfolio holding periods and levels of investor risk aversion, which are subsequently compared with those that stem from the standard mean-variance optimization framework. Then, using an extensive dataset of 21 countries over 120 years, optimal asset allocations are determined for each country, for several portfolio holding periods and levels of investor risk aversion. Finally, the technique suggested to infer an investor’s risk aversion coefficient is discussed.
You can find the paper here
You can find the abstract (and PDF) at:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3903851
That’s all for today :) For more Quant Finance treats, check out our archives.
Stay quanty!
All the best,
Sebastian
What do you think of today's email?
Hit reply and let me know (5 stars = great, 3 stars = good, but not great, 1 star = yikes)