Portfolio Selection, Periodic Evaluations and Risk Taking

We present a continuous-time portfolio selection problem faced by an agent with S-shaped preference who maximizes the utilities derived from the portfolio’s periodic performance over an infinite horizon. The periodic reward structure creates subtle incentive distortion. In some cases, local risk aversion is induced, which discourages the agent from risk taking in the extreme bad states of the world. In some other cases, eventual ruin of the portfolio is inevitable, and the agent underinvests in the good states of the world to manipulate the basis of subsequent performance evaluations. We outline several important elements of incentive design to contain the long-term portfolio risk.

Funding: H. Zheng is supported in part by the Engineering and Physical Sciences Research Council [Grant EP/V00833/1].

Supplemental Material: The e-companion is available at https://doi.org/10.1287/opre.2021.0780.