Long-term dynamic asset allocation under asymmetric risk preferences

We examine the impact of return predictability and parameter uncertainty on long-term portfolio allocations when investors’ utility function quantifies their asymmetric behaviour against expected gains and losses on risky assets. Allowing for different return generating systems and two investable assets, we examine the way portfolio allocation to the risky asset evolves over the course of the investment horizon in the presence of risk asymmetries. We find persisting horizon effects, with stocks appearing progressively more attractive at longer horizons as opposed to shorter ones. The role of parameter uncertainty also appears to be prominent in the portfolio choice problem. Accounting for this results in both significantly lowering the exposure to the risky asset and lessening the horizon effects driven by return predictability. An equally important aspect of this study relates to detecting a level of disappointment aversion below which it is optimal for investors to hold zero units of a risky asset. In this regard, our analysis has implications for the nonparticipation puzzle in stock markets.