Lecture 7: Strategic Asset Allocation

Mark-Jan Boes

March 1, 2023
 Part I

Introduction

Lecture 7
Mark-Jan Boes 1
Motivation

Over the past weeks we have been looking mainly at managing

risks on the balance sheet:
interest rate risk: how do interest rate fluctuations impact
surplus / capital
counterparty credit risk: what is the impact of a default of
a counterparty in a derivatives contract?
inflation risk: what is the impact of an unexpected rise in
inflation?

But investments is about the tradeoff between risk and

expected return.

Lecture 7
Mark-Jan Boes 2
Motivation

Qualitatively, the portfolio choice problem is about:

1 Define your goals: what is your ambition?
2 Minimize risk conditional on the goals
3 Verify whether risk is acceptable

If the risk turns out to unacceptable, then there are two choices:
1 lower the ambition
2 change the attitude towards risk

Lecture 7
Mark-Jan Boes 3
Motivation

Basic principles:
risks that do not offer a compensation should be avoided (i.e.
hedged) as much as possible
all risks of investing in a financial instrument should be well
understood
the risk premium of a financial instrument should be in line
with business / personal preferences
only invest in well-diversified portfolios, i.e. avoid unnecessary
specific risks

Ok, makes sense, but what are the tools that we can use to decide
on the investment of EUR 4 bln?

Lecture 7
Mark-Jan Boes 4
Return distribution volatility product

Probability distribution of monthly returns of volatility strategy

January 1990 - July 2004
40.0%

35.0%

30.0%

25.0%
probability

20.0%

15.0%

10.0%

5.0%

0.0%
<-15%

-15% - 12.5%

-12.5% - -10%

-10% - -7.5%

-7.5% - -5%

-5% - -2.5%

-2.5% - 0%

0% - 2.5%

2.5% - 5%

5% - 7.5%

7.5% - 10%

10% - 12.5%

>15%
monthly return (USD)

Lecture 7
Mark-Jan Boes 5
Portfolio Choice

Volatility strategy Equities

Mean 9.9% 9.7%
Standard deviation 15.2% 15.1%
Skewness -8.3 -0.6
Kurtosis 104.4 4.0

Which strategy would you choose?

Lecture 7
Mark-Jan Boes 6
Coming lectures

What can you expect from the coming series of lectures?

Today: what does academic theory tell us about portfolio
choice without liabilities?
Friday: what does academic theory tell us about portfolio
choice in the presence of liabilities?
Wednesday March 8: how do pension funds decide on their
asset allocation in practice (with Ortec Finance)?
Friday March 10: case study on practical decision making for
pension funds (with Ortec Finance)
Wednesday March 22: presentation of your case solutions
(with Ortec Finance)

I will only talk about the choice between asset classes.

Construction of the most efficient equity portfolio is also a very

interesting topic, but unfortunately I don’t have time to cover that.
Lecture 7
Mark-Jan Boes 7
 Part II

Academic approach - expected utility

maximization

Lecture 7
Mark-Jan Boes 8
Academic approach

Expected utility maximization:

wt∗ = arg max Et (U(W (T ))).

w

Looks very simple but one needs to make a lot of choices:

How do we measure wealth?
How does the world look like? i.i.d. returns, VAR(1)?
What is the utility function?
What is the evaluation / investment horizon?
Can investors adjust the portfolio between t and T (static or
dynamic problem)?
What is the risk free asset for the investor?

Lecture 7
Mark-Jan Boes 9
Academic approach

Expected utility maximization for mean-variance preferences:

γ
wt∗ = arg max Et (Rt:t+h
P
)− P
Vart (Rt:t+h ).
wt 2
Going through the list of questions:
How do we measure wealth? by the realized portfolio return
How does the world look like? you can assume normal returns
but not necessary
What is the utility function? see above
What is the evaluation / investment horizon? h
Can investors adjust the portfolio between t and T ? static,
1-period problem
What is the risk free asset? cash, because horizon is typically
short
Lecture 7
Mark-Jan Boes 10
Academic approach

Markowitz showed how investors should pick assets if they care

only about the mean and variance of portfolio returns over a single
period.
Lecture 7
Mark-Jan Boes 11
Academic approach

Remember that mean-variance is only optimal, i.e. delivers

efficient portfolios only if
investors have quadratic utility or
returns are elliptically (e.g. normally) distributed

What is also important to remember about the classical

mean-variance approach:
you need full knowledge on the parameters
optimal portfolios are extremely sensitive for parameter choices
one period model (usually short term)
often applied to equities: the closely related CAPM is a model
in which only one risk factor is priced

Lecture 7
Mark-Jan Boes 12
Academic approach

What is the solution of the optimization problem?

Let us consider a case with just two assets available at time t:

f
A riskless asset with simple net return Rt:t+1 from time t
to t + 1
A risky asset with simple return Rt:t+1 from time t to t + 1
with conditional mean Et (Rt:t+1 ) and conditional variance σt2

The conditional mean and conditional variance are the mean and
variance conditional on the investor’s information at time t, thus
they are written with t subscripts.

Lecture 7
Mark-Jan Boes 13
Academic approach

The investor puts a share wt of his portfolio into the risky asset.

Then the portfolio return is:

P f f f
Rt:t+1 = wt Rt:t+1 + (1 − wt )Rt:t+1 = Rt:t+1 + wt (Rt:t+1 − Rt:t+1 )

Portfolio characteristics:
P
Et (Rt:t+1 f
) = Rt:t+1 f
+ wt (Et (Rt:t+1 ) − Rt:t+1 )
2 = w 2σ2
σpt t t

Lecture 7
Mark-Jan Boes 14
Academic approach

We can enter these portfolio characteristics in the objective

function now:
f f γ 2 2
max Et (Rt:t+1 + wt (Et (Rt:t+1 ) − Rt:t+1 )) − w σ
wt 2 t t

The solution to this maximization problem delivers the optimal

weight in the risky asset:
f
Et (Rt:t+1 ) − Rt:t+1
wt∗ = .
γσt2

Please note that we’ve made an assumption on the utility function

and not on the distribution of the risky asset return.

Lecture 7
Mark-Jan Boes 15
Academic approach

The optimal solution in case of more risky assets:

Σ−1
t µt
wt∗ =
γ
where:
Σt is the variance-covariance matrix of the returns on risky
assets
µt is the time-t vector of expected excess returns on risky
assets
γ is risk aversion
Obvious consequence: if γ = ∞ then the weight in risky assets is
zero and hence all money is invested in the risk free asset.

Lecture 7
Mark-Jan Boes 16
Mean variance approach

From here on we can take many different directions.

Let us first stay in the 1-period setting where the single period
covers a small time interval.

Furthermore, we want to derive portfolio choice results under the

assumption that:
investors have power utility
asset returns are lognormally distributed

This is typical for model-based portfolio choice problems: choices

have to be made with respect to risk preferences and the outcome
distribution of risky assets.

Lecture 7
Mark-Jan Boes 17
Power utility

As you know, power utility is given by:

WT1−γ
U(WT ) = .
1−γ
Can we relate expected utility based on power utility relate to
mean-variance utility?

Taylor expansion of U(WT ) around E(WT ):

U(W (T )) ≈ U(E(WT )) + U 0 (E(WT ))(WT − E(WT ))

1
+ U 00 (E(WT ))(WT − E(WT ))2
2
1 000
+ U (E(WT ))(WT − E(WT ))3 + ...
6

Lecture 7
Mark-Jan Boes 18
Power utility

Now taking expectations left and right yields:

1
E(U(W (T ))) ≈ U(E(WT )) + 0 + U 00 (E(WT ))Var (WT )
2
1 000
+ U (E(WT ))E(WT − E(WT ))3 + ...
6

Given that the power utility function is concave, the formula shows
that the variance of wealth contributes negatively to expected
utility.

The formula also shows that higher order moments of the wealth
distribution at time T are important for expected utility and
therefore for optimal portfolio choice.
unless of course the wealth distribution is normal
Lecture 7
Mark-Jan Boes 19
Power utility

Assume now, for ease of illustration, that the distribution of

wealth is lognormal. Then we know:
1 1 2
log(Et (Wt+1 )) = Et (log(Wt+1 ))+ Vart (log(Wt+1 )) = Et (wt+1 )+ σwt .
2 2
This follows from the relation between the moments of the normal
and lognormal distribution.

To find the optimal portfolio under these assumptions we have to

maximize expected utility:
1−γ
Et (Wt+1 )
max
αt 1−γ
where we impose (available wealth is fully invested in the portfolio):
P
Wt+1 = Wt (1 + Rt:t+1 ).

Lecture 7
Mark-Jan Boes 20
Power utility

The objective function can be rewritten as:

1−γ 1
max log(Et (Wt+1 )) = (1 − γ)Et (wt+1 ) + (1 − γ)2 σwt
2
αt 2
The budget constraint can be written in log form as:
P
wt+1 = rt:t+1 + wt ,
P
where rt:t+1 P
= log(1 + Rt:t+1 ), the continuously compounded
portfolio return.

Using the budget constraint and dividing by (1 − γ) yields the

following optimization problem:

P 1 2
max Et (rt:t+1 ) + (1 − γ)σpt
αt 2
Lecture 7
Mark-Jan Boes 21
Power utility

Using the properties of the distributions we can again rewrite to:

P γ 2
max log(Et (1 + Rt:t+1 )) − σ
αt 2 pt

Just as in the mean-variance analysis, the investor trades off mean

against variance in portfolio return.

But be aware that the distribution assumption has an impact on

the optimal portfolio.

Lecture 7
Mark-Jan Boes 22
Power utility

We have assumed that wealth and portfolio return were

lognormally distributed.

However, if risky assets are lognormally distributed then a

portfolio is not lognormally distributed.

Over a short time interval, however, we use a Taylor

approximation, ultimately leading to the following optimal portfolio
(in case of a risk free asset and one risky asset):
f
Et (rt:t+1 ) − rt:t+1 + 12 σt2
αt∗ = .
γσt2

This equation is the equivalent, in a lognormal model with power

utility, of the original mean-variance solution.
Lecture 7
Mark-Jan Boes 23
Long term portfolio choice

We could use all this to determine the optimal portfolio for an

investor with a short investment horizon and who cares only about
the distribution of wealth at the end of the next period.

But how can we decide on the optimal portfolio for a long term
investor?

The long term investor’s optimal portfolio depends not only on his
objective but also on what he is allowed to do each period.

Specifically, I distinguish between three types of investors:

a buy-and-hold investor: no possibility to adjust portfolio
between moment of purchase and the investment horizon
a myopic investor: has the possibility to adjust and adjusts
as if he is a short term investor
a dynamic investor: has the possibility to adjust but takes a
longer perspective than the myopic investor
Lecture 7
Mark-Jan Boes 24
Long term portfolio choice: the buy-and-hold investor

We continue to assume that all wealth is reinvested, so the budget

constraint takes the form:
P P P
Wt+K = (1 + Rt:t+1 )(1 + Rt+1:t+2 )...(1 + Rt+K −1:t+K )Wt .

The log-return over K periods is just a sum of K successive

one-period returns:
P P P P
rt:t+K = rt:t+1 + rt:t+2 + ... + rt+K −1:t+K .

We assume (as before):

power utility
asset returns are conditionally lognormally distributed

Lecture 7
Mark-Jan Boes 25
Long term portfolio choice: the buy-and-hold investor

What can we say about the optimal portfolio for the buy-and-hold
investor?

Not much: we need to make additional assumptions for the asset

returns and interest rates.

We could impose that all asset returns are independent and

identically distributed:
there is no autocorrelation in asset returns
the mean and variance is the same in each period

We assume interest rates to be constant through time.

Lecture 7
Mark-Jan Boes 26
Long term portfolio choice: the buy-and-hold investor

All these assumptions imply that we can adjust the formula derived
earlier for K periods (slide 23):

f
Et (rt:t+K ) − rt:t+K + 12 σKt
2
wt∗ = 2
γσKt
f
K Et (rt:t+1 ) − Krt:t+1 + 21 K σt2
=
K γσt2
f
Et (rt:t+1 ) − rt:t+1 + 12 σt2
=
γσt2

In other words: under our assumptions the optimal portfolio is

independent of the horizon!

Lecture 7
Mark-Jan Boes 27
Asset allocation in an asset-only framework

Barberis (2000) confirms this conclusion in his first analysis.

Step 1: Simulate 1,000,000 paths for continuously compounded
equity returns (normally distributed).

Step 2: For each path calculate the cumulative return of equity

over the investment horizon.

Step 3: Choose portfolio allocation.

Step 4: Conditional on portfolio allocation, calculate end of period

utility for each path and average over paths.

Step 5: Repeat Step 4 for many different portfolio allocations: the

portfolio allocation with the largest average utility, is the optimal
portfolio.

Lecture 7
Mark-Jan Boes 28
Barberis: analysis 1

Results are shown as dash-dotted lines in the following figure:

Observations:
optimal allocation in equity depends heavily on risk aversion A
optimal allocation in equity does not depend on horizon
Lecture 7
Mark-Jan Boes 29
Barberis: analysis 1

The second observation is explained by the model for stock index

returns.

The ratio of excess return over variance does not depend on

horizon.

Therefore the optimal weight in equities is the same for each

horizon.

Lecture 7
Mark-Jan Boes 30
Barberis: analysis 1

Conclusion:

Horizon does not matter for optimal investing under the following
conditions:
power utility
returns are independent and identically distributed
risk attitude does not vary with horizon
full knowledge on the model parameters

Lecture 7
Mark-Jan Boes 31
Barberis: analysis 1

The importance of the last condition is shown by the solid line:

Lecture 7
Mark-Jan Boes 32
Barberis: analysis 1

What do we mean by estimation error?

Consider the following model for stock index returns:

rt:t+h = µ + εt:t+h
where

εt:t+h ∼ N(0, σ 2 )

µ is an unobservable parameter, so we need to estimate this

parameter. How?

Lecture 7
Mark-Jan Boes 33
Barberis: analysis 1

Usually, we take as an estimate the historic average returns:

T
1 X
µ̂ = rt:t+h .
T
t=1

we also know that around each estimate, we have a standard error

which is (in our setting):
σ
se(µ̂) = √ ,
T
where σ can be estimated by the standard deviation of historic
returns.

Lecture 7
Mark-Jan Boes 34
Barberis: analysis 1

For monthly returns, for instance:

µ̂ = 0.5% and the standard error of µ̂ is 0.18%.

Consequently:

The 95% confidence interval for the true, unobservable µ is:

95%CI = [0.15%; 0.85%].

Lecture 7
Mark-Jan Boes 35
Barberis: analysis 1

This interval is huge: statistically, you cannot reject that the true
µ differs from 0.15%.

Using 0.15% as an expected return on stocks instead of 0.50% has

a dramatic impact on the optimal allocation towards equities.

This is one of the main reasons why mean-variance optimal

portfolios perform so poorly out-of-sample.

Lecture 7
Mark-Jan Boes 36
Barberis: analysis 1

Andrew Ang shows this in two analyses.

First, he analyzes estimation error in a setting where he can choose

between:
US equity
Japanese equity
UK equity
German equity
French equity

He first assumes a 10.3% expected return on US equities. After

that he changes the expected return to 13.0%. The required return
on the portfolio is 12%.

Lecture 7
Mark-Jan Boes 37
Barberis: analysis 1

Optimal mean-variance portfolios:

Lecture 7
Mark-Jan Boes 38
Barberis: analysis 1

In his second analysis he analyzes the out-of-sample performance

of mean-variance optimization and alternative approaches:
market capitalization weights
diversity weights
equal weights
risk parity (variance): weights inversely proportional to
variance
risk parity (volatility): weights inversely proportional to
variance
minimum variance portfolio
equal risk contributions

Lecture 7
Mark-Jan Boes 39
Barberis: analysis 1

Results:

Lecture 7
Mark-Jan Boes 40
Barberis: analysis 1

Barberis shows that the negative impact of estimation error on

stock allocation increases with horizon.

For a risk averse investor (γ = 10) with a horizon of 10 years, the

optimal allocation towards equities decreases with 50% (from 40%
to 20%) because of this estimation error.

Exactly for this reason I am not a big fan of doing portfolio

optimization with long horizons.

Lecture 7
Mark-Jan Boes 41
Asset allocation in an asset-only framework

What do we know about asset allocation in an asset-only

framework if we would relax the assumption of i.i.d. returns?

That would be very dependent on the dynamics that are assumed.

a typical assumption is that equities are mean reverting (due

to predictability): equity volatility measured over long
horizons is smaller than for short horizons.
consequence: in a static framework, investors with a long
investment horizon allocate more money to equities than
investors with a short horizon.
reason is that short term characteristics of asset classes differ
from long term characteristics.

Lecture 7
Mark-Jan Boes 42
Barberis: analysis 2

Barberis illustrates these points in a VAR(1)-model.

zt = a + Bxt−1 + t
where

zt = (rt , xt )0 ,
xt is the dividend yield,

and

t ∼ N(0, Σ)

Lecture 7
Mark-Jan Boes 43
Barberis: analysis 2

Parameter estimates:

Lecture 7
Mark-Jan Boes 44
Barberis: analysis 2

Conditional on the assumption that these parameter estimates are

true, the estimates imply a negative autocorrelation in returns.

Remember that the i.i.d. assumption of analysis 1 implies that

there is zero autocorrelation in returns.

Compared to the i.i.d. case negative serial correlation leads to

lower risks on equities measured over longer horizons. That makes
equities more attractive for long term investors.

Lecture 7
Mark-Jan Boes 45
Barberis: analysis 2

dotted and dash/dotted lines same as in analysis 1

dashed line: optimal equity allocation in case of predictability
solid line: optimal equity allocation in case of predictability
and parameter uncertainty

Lecture 7
Mark-Jan Boes 46
Barberis: analysis 2

Two obvious conclusions from the results:

predictability of returns by the dividend yield leads to a
significantly higher allocation in equities
parameter uncertainty again leads to a reduction in equities,
but equity allocation is still considerably higher than in the
i.i.d. case

But most important: in a static framework, buy-and-hold long

term investors show different investment behaviour than short term
investors.

Lecture 7
Mark-Jan Boes 47
Asset allocation in an asset-only framework

What else do we know?

Long term investors usually do not choose a buy-and-hold strategy,

i.e. long term investor invest dynamically, they change their asset
allocation over time.

Long term investors can do this by acting myopically, i.e. solving a

series of consecutive short term portfolio choice problems and
adjust the portfolio accordingly (myopic investing).

In a world where returns are i.i.d. and the investor has power
utility, the optimal asset allocation would be identical through time:
the myopic investor would rebalance regularly to this asset mix.

Lecture 7
Mark-Jan Boes 48
Asset allocation in an asset-only framework

In a world where returns are not i.i.d., the myopic investor would
update expected returns, variances and covariances at the
rebalancing date and would determine the new optimal asset mix.

The myopic investor does not exploit any intertemporal correlations

between asset classes because he is focussed on the short term.

Theory says, however, that in the presence of intertemporal

correlation between returns and / or changes in interest rates, long
term investors should exploit these dependencies.

Long term investors should act like short term investors but, in
addition to that, also have so-called ’hedging demands’.

Ang correctly points out that these hedging demands, or

opportunistic weights, go anywhere in the empirical literature and
therefore he suggests to ignore them.
Lecture 7
In that case the long term investor
Mark-Jan Boes 49 acts exactly as a short term
Barberis: analysis 3

Barberis looks at the dynamic investment strategy in his third

analysis.

Due to the predictability the investment opportunity set (i.e. the

ratio of excess returns over variance) changes over time.

Investors may want to hedge these changes by investing in a way

that gives them higher wealth precisely when investment
opportunities are unattractive, i.e. when expected returns are low.

Lecture 7
Mark-Jan Boes 50
Barberis: analysis 3

What does it mean in this specific setting? It is all driven by the

dynamics of the model.

Compared to the i.i.d. case equity investment will be higher.

A higher allocation to equities at time t will lead to a higher

wealth at time t + 1 if a positive shock to equities has occurred
between t and t + 1.

In the estimated VAR-model a positive shock in equities comes

together with a negative shock in the dividend yield (with high
probability).

Lower values of the dividend yield, lead to a lower expected return

on equity at time t + 1, i.e. unattractive investment opportunities.

Lecture 7
Mark-Jan Boes 51
Barberis: analysis 3

Therefore, a high allocation to equities provides a kind of hedge

against unattractive states of the world, i.e. situations of
unattractive investment opportunities.

I.e., unattractive investment opportunities occur at times of high

wealth (again with high probability).

Lecture 7
Mark-Jan Boes 52
Barberis: analysis 3

Conclusions are qualitatively the same as for analysis 2:

predictability of returns by the dividend yield leads to a
significantly higher allocation in equities compared to the i.i.d.
case
parameter uncertainty again leads to a reduction in equities,
but equity allocation is still considerably higher than in the
i.i.d. case

Lecture 7
Mark-Jan Boes 53
Asset allocation

Ang splits the long run weight at a particular point in time in:
short run weight
opportunistic weight
The short run weight is the weight a short term investor would
choose; it can vary through time because expected returns and
variance vary through time.

The opportunistic weight is the hedging demand: long run

investors do everything short run investors do plus they can act
opportunistically in a manner that short run investors cannot.

He calls the long run weights, the strategic asset allocation, the
portfolio allocation a long term investor really wants to have.

Lecture 7
Mark-Jan Boes 54
Asset Allocation

My personal opinion is that the evidence for predictability is not

particularly strong. I would ignore it: the risk of being wrong is
simply too high.

Most value can be obtained by an optimal rebalancing strategy: if

you look at markets over the past couple of decades then the thing
that stands out is that strong upward and downward movements
are corrected.

Note (again) that rebalancing should also be done in an i.i.d.

world (in a dynamic setting); the hedging demand would disappear
and the short run weight is independent of time.

Lecture 7
Mark-Jan Boes 55
Asset Allocation

Note that we’ve only looked at the return assumptions in an

asset-only context.

A lot of things can be said about it, don’t you think?

But you could also look at the utility function: how do we

appreciate tail risk?

Most analyses assume power utility and / or (conditional) normal

returns which make the investment problem much more tractable.

Lecture 7
Mark-Jan Boes 56
Higher moments

However, the real world looks a bit different:

’fat left tails’, i.e. occurs when extreme negative returns are
observed with a magnitude and frequency greater than implied
by the ’normal’ distribution.
correlation breakdown in joint asset class returns, i.e. occurs
during periods of high market volatility and is typically not
captured by linear correlation matrices

Lecture 7
Mark-Jan Boes 57
Higher moments

Illustration: correlations versus US equities

Long run correlation In market stress
US Bonds -0.21 -0.02
REITs 0.31 0.58
Hedge Fund of Funds 0.46 0.60
Private Equity 0.61 0.86

Lecture 7
Mark-Jan Boes 58
Higher moments

How do these empirical regularities affect portfolio choice?

We will analyze this in a somewhat more pragmatic framework

than before.

We will use conditional value-at-risk (CVaR) as the risk metric: we

define CVaR for the purpose of this exercise as the average
portfolio loss in the worst 5% of scenarios.

I.e. we deviate from the power utility world by formulating explicit

preferences about tail risks.

Lecture 7
Mark-Jan Boes 59
Higher moments

Lecture 7
Mark-Jan Boes 60
Higher moments

On the next slide I’ll presents something that looks very familiar to
a mean-variance efficient frontier.

However, on the x-axis CVaR is shown as risk measure.

The ’normal framework’ line shows optimal portfolios under the

assumption that returns on all asset classes are normally
distributed.

The ’non-normal CVaR framework’ shows optimal portfolios under

returns that are more realistically distributed and under
minimization of CVaR for a given level of required return.

Lecture 7
Mark-Jan Boes 61
Higher moments

Lecture 7
Mark-Jan Boes 62
Higher moments

It looks as if the normal framework delivers more efficient

portfolios but please notice that the risk measure is also calculated
under the assumption of normally distributed returns.

Unreported results show that in the CVaR-framework the minimum

risk portfolio has a higher allocation towards bonds than in the
normal framework.

These unreported results also show that much more money is

allocated to traditional asset classes like listed equity and much
less to alternative like private equity.

Lecture 7
Mark-Jan Boes 63
 HigherEmoments
xhibit 18
Optimization Results
this article, forward to an unauthorized user or to post electronically without Publisher permission.
tments 2009.12.3:8-35. Downloaded from www.iijournals.com by CAIA on 05/21/10.

Note: Sharpe ratio calculated assuming risk-free return of 4.0%.

Source: J.P. Morgan Asset Management. For illustrative purposes only.
Lecture 7
Mark-Jan Boes 64
$205 million we calculate in the last section. We assume However, the more significant issue by far—and
Higher moments

The following observations:

a simple and pragmatic portfolio solution like the ’current
allocation’ gives surprisingly good results
the normal framework provides a solution which is heavily
tilted towards alternatives: in practice this solution is very
difficult to ’sell’ to the board
the CVaR framework provides results that look fairly
reasonable

Question: if you were an advisor, which solution would you

propose?

Lecture 7
Mark-Jan Boes 65
Summary

What do we learn from all this and could be of value for the
pension fund portfolio choice problem?
In general, portfolio choice is about:
modelling the world (i.e. state variables and asset classes)
over the full investment period
determining the utility function: which goals and which risks
are important?
choosing the type of investor: buy-and-hold, myopic or
dynamic investor?
maximizing expected utility

Lecture 7
Mark-Jan Boes 66
Summary

What do we know about portfolio choice in an asset-only context?

long term investors should invest dynamically, even if they
think the world is i.i.d.
an optimal dynamic strategy is difficult to find (analytically)
unless the world is i.i.d.
estimation risk is important and its importance increases with
the investment horizon
predictability of equity returns has a great impact on long
term optimal portfolio allocation but the statistical evidence
for predictability is rather thin
if the evaluation horizon of an investment strategy is very far
in the future, the choice for a particular investment strategy is
extremely sensitive for the dynamics of the model

Lecture 7
Mark-Jan Boes 67
Summary

Learning points continued:

tail risk preferences can have a big impact on optimal
portfolio choice
usually portfolio evaluation criteria (e.g. Sharpe ratio) are not
very sensitive for small changes in the strategy: use intuitive
and explainable portfolio weights

Lecture 7
Mark-Jan Boes 68