Downside Loss Aversion and Portfolio Management

Downside loss averse preferences have seen a resurgence in the portfolio management literature. This is due to the increasing usage of derivatives in managing equity portfolios, and the increased usage of quantitative techniques for bond portfolio management. We employ the lower partial moment as a risk measure for downside loss aversion, and compare mean-variance (M-V) and mean-lower partial moment (M-LPM) optimal portfolios under non-normal asset return distributions. When asset returns are nearly normally distributed, there is little difference between the optimal M-V and M-LPM portfolios. When asset returns are non-normal with large left tails, we document significant differences in M-V and M-LPM optimal portfolios. This observation is consistent with industry usage of M-V theory for equity portfolios, but not for fixed income portfolios. Jarrow is from Johnson Graduate School of Management, Cornell University, Ithaca, NY 14853 ([email protected]). Zhao is from Rutgers Business School, Rutgers University, Newark, NJ 07102 ([email protected]). We thank David Hsieh (the editor), the associate editor and an anonymous referee for the helpful suggestions. We are responsible for any remaining errors.