Traditional Optimization is Not Optimal for Leverage-Averse Investors

Posted: 2 Oct 2013 Last revised: 5 Jun 2014

See all articles by Bruce I. Jacobs, Ph.D.

Bruce I. Jacobs, Ph.D.

Jacobs Levy Equity Management

Kenneth N. Levy

Jacobs Levy Equity Management

Date Written: October 1, 2013

Abstract

Leverage entails a unique set of risks, such as margin calls, which can force investors to liquidate securities at adverse prices. Investors often seek to mitigate these risks by using a leverage constraint in conventional mean-variance portfolio optimization. Mean-variance optimization, however, provides the investor with little guidance as to where to set the leverage constraint, so it is unable to identify the portfolio offering the highest utility. An alternative approach — the mean-variance-leverage optimization model — allows the leverage-averse investor to determine the optimal level of leverage, and thus the highest utility portfolio, by balancing the portfolio’s expected return against the portfolio’s volatility risk and its leverage risk.

Keywords: Risk Management, Modern Portfolio Theory, Portfolio Choice, Portfolio Optimization, Mean Variance Optimization, Efficient Frontier, Efficient Surface, Leverage Constraint, Risk Aversion, Volatility Aversion, Volatility Tolerance, Leverage Aversion, Leverage Tolerance, Portfolio Optimality, Leverage

JEL Classification: G11

Suggested Citation

Jacobs, Bruce I. and Levy, Kenneth N., Traditional Optimization is Not Optimal for Leverage-Averse Investors (October 1, 2013). The Journal of Portfolio Management, Vol. 40, No. 2, Winter 2014, Available at SSRN: https://ssrn.com/abstract=2334407

Bruce I. Jacobs (Contact Author)

Jacobs Levy Equity Management ( email )

100 Campus Drive
P.O. Box 650
Florham Park, NJ 07932-0650
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HOME PAGE: https://jlem.com/who-we-are#/nav/founders

Kenneth N. Levy

Jacobs Levy Equity Management ( email )

100 Campus Drive
P.O. Box 650
Florham Park, NJ 07932-0650
United States
973-410-9222 (Phone)
973-410-9333 (Fax)

HOME PAGE: https://jlem.com/who-we-are#/nav/founders

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