Regret and Optimal Portfolio Allocations

Abstract

Although regret can impact the ex post perceived quality of investment decisions, it is not something that is typically explicitly considered when building portfolios. Even so, both retail investors (i.e., households), who tend to be less sophisticated and more likely to exhibit trend chasing, and institutional investors, who tend to have either implicit or explicit performance benchmarks, are subject to regret. This article introduces an objective function to incorporate regret aversion into portfolio optimizations as a parameter distinct from risk aversion and explores the implications of regret on an individual stock portfolio. Considering regret can result in notable changes in optimal portfolio weights, leading to higher allocations to relatively inefficient and potentially risky assets, although the portfolio impact varies depending on investor preferences and modeling assumptions.