Title: Asset Allocation with Power-Log Utility Functions
Abstract: This study shows how portfolio optimization with Power-Log utility functions can be used to harness the enormous quantity of investment information that is available, to construct portfolios with high growth potential and downside protection using all types of securities, mutual funds and exchange traded funds. It also compares this method of portfolio construction with mean-variance optimization in a strategic asset allocation framework. It uses major asset classes to show that optimal Power-Log utility portfolios have lower downside risk and higher upside potential than mean-variance efficient portfolios. In addition it shows that intermediate term bond funds should be given greater weight in conservative portfolios than mean-variance optimization suggests. The enormous increase in the types of investment assets that are available globally, and the explosion of information on stocks, bonds, futures, options, mutual funds, and most recently exchange traded funds, has increased the need for sophisticated systems to incorporate this information for building the kinds of portfolios that investors desire. The traditional method of portfolio construction, mean-variance analysis, cannot account for the significant higher moments in the return distributions of bond funds and derivatives. This study shows how a new portfolio optimization methodology based on Power-Log utility functions can be used for asset allocation with all types of securities and funds, when portfolio growth and downside protection are both important. Strategic asset allocation is the process of selecting asset classes and their relative weights to construct optimal portfolios that are held over long time horizons. The mean-variance framework for portfolio selection developed by Markowitz (23) is a one-period model that is used widely for asset allocation, but there are other methods for portfolio selection. Multiperiod portfolio theory based on log and power utility functions has been discussed by Kelly (16) and others. Behavioral finance gives us a different perspective on investor actions based on prospect theory, proposed by Kahneman and
Publication Year: 2008
Publication Date: 2008-01-01
Language: en
Type: article
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