Suboptimal investment behavior and welfare costs: A simulation based approach

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Abstract

We propose a representation of suboptimal investment behavior based on the stochastic discount factor (SDF) paradigm. Suboptimal investment behavior is rationalized as being the investor's optimal decision under a wrong SDF, while wealth trajectories and budget constraints are based on the true SDF. We develop a novel Monte Carlo simulation approach to compute the welfare costs for this suboptimal behavior. We study the suboptimal portfolio choice under CRRA preferences using two financial market models. The Monte Carlo simulation delivers comparable welfare losses to those computed in the original studies, which are based on partial differential equations (PDE) and - finite-difference schemes.

Original languageEnglish
Pages (from-to)170-180
Number of pages11
JournalFinance Research Letters
Volume30
DOIs
StatePublished - Sep 2019

Keywords

  • Asset allocation
  • Martingale method
  • Monte Carlo simulation
  • Portfolio selection
  • Suboptimal investment
  • Welfare loss

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