Applied Probabilistic Calculus for Financial Engineering

5Assets Allocation Using R

5.1 Risk Aversion and the Assets Allocation Process

The main objectives for asset allocation include the maximizing of returns, with/without periodic incomes derived from the returns. During these processes, the investor may freely use assets allocation to achieve such goals. Moreover, it certainly should not escape one's attention that the process of assets allocation is laden with the state of risk aversion on the part of the investors.

A growing body of research investigates whether investor risk aversion varies over time. Determining risk aversion is becoming increasingly important both in the United States and internationally for compliance and suitability purposes among financial advisors who are building portfolios for their clients. It appears that significant evidence has been established that risk aversion is time varying and that changes in risk aversion are primarily related to changes in investor expectations instead of historical market returns. Time-varying risk aversion carries important implications for the demand for risky assets if investors reduce demand for stocks when valuations are most attractive. It is noted that a statistically significant relation exists between time-varying risk aversion and net equity mutual fund flows, or a variable risk preference bias. It is found that net equity flows for more sophisticated investors, such as those who use index (versus active) mutual funds and purchase institutional equities.

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