Downside loss aversion: winner or loser? (Q2350935)

The authors study the asset allocation of a quadratic loss averse (QLA) investor whose utility of returns is linear in gains and quadratic in losses. The relationship between the quadratic loss-averse utility maximization problem and both the mean-variance (MV) and conditional value-at-risk (CVaR) is shown and certain conditions are derived under which the QLA problem is equivalent to the MV and CVaR problems. The authors solve analytically the two-asset problem of the QLA investor for one risk-free and one risky asset. They also implement the trading strategy of a QLA investor who reallocates his portfolio on a monthly basis for a portfolio consisting of 13 EU and 13 USA assets. Using risk adjusted performance measures that do not target specific types of utility, the authors compare QLA portfolios with MV, CVaR and linear loss-averse (LLA) portfolios. It is shown that QLA portfolios outperform MV and CVaR portfolios. Compared with LLA, QLA portfolios display less risk but also lower returns.