Traditional Optimization is Not Optimal for Leverage-Averse Investors
Posted: 2 Oct 2013 Last revised: 5 Jun 2014
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: Suggested Citation