Portfolio Selection, Periodic Evaluations and Risk Taking

We present a continuous-time portfolio selection problem faced by an agent with S-shaped preference who maximizes the utilities derived from the portfolio's periodic performance over an infinite horizon. The periodic reward structure creates subtle incentive distortion. In some cases, local risk aversion is induced, which discourages the agent from risk taking in the extreme bad states of the world. In some other cases, eventual ruin of the portfolio is inevitable, and the agent underinvests in the good states of the world to manipulate the basis of subsequent performance evaluations. We outline several important elements of incentive design to contain the long-term portfolio risk.

Automated summary

This paper examines a continuous-time portfolio selection problem faced by an agent with S-shaped preference, aiming to maximize utilities derived from the portfolio's periodic performance over an infinite horizon. The periodic reward structure leads to subtle incentive distortion, inducing local risk aversion in some cases, and causing underinvestment in the good states to manipulate subsequent performance evaluations in other cases. The authors outline several important elements of incentive design to mitigate long-term portfolio risk.