Better Safe than Sorry: Bulls, Bears, and Optimal International Portfolio Choice under Disappointment Aversion

This paper examines optimal international portfolio choice when equity market linkages increase during periods of distress and investors are averse to disappointing outcomes. I propose a model that captures the joint effect of these two phenomena and show that it leads to a first-order effect on the optimal portfolios. Even during correlated downturns, international diversification is still highly valuable in utility terms. However, including return predictability significantly increases the attractiveness of US stocks and can create substantial home bias in more favorable states of the economy. Furthermore, the model can help rationalize the empirically documented use of “returnchasing” strategies and creates significant intertemporal hedging demands even in the absence of return predictability. An expected utility model cannot replicate the results merely by increasing curvature because the effective degree of risk aversion is strongly regime dependent.