Portfolio Selection in Quantile Utility Models

L. De Castro, A. Galvao, G. Montes-Rojas and J. Olmo (2022). Portfolio Selection in Quantile Utility Models. Annals of Finance 18, 133-181.

This paper develops a model for optimal portfolio allocation for an investor with quantile preferences, i.e., who maximizes the tau-quantile of the portfolio return, for tau in (0, 1). Quantile preferences allow to study heterogeneity in individuals' portfolio choice by varying the quantiles, and have a solid axiomatic foundation. Their associated risk attitude is captured entirely by a single dimensional parameter (the quantile tau), instead of the utility function. We formally establish the properties of the quantile model. The presence of a risk-free asset in the portfolio produces an all-or-nothing optimal response to the risk-free asset that depends on investors' quantile preference. In addition, when both assets are risky, we derive conditions under which the optimal portfolio decision has an interior solution that guarantees diversification vis-a-vis fully investing in a single risky asset. We also derive conditions under which the optimal portfolio decision is characterized by two regions: full diversification for quantiles below the median and no diversification for upper quantiles. These results are illustrated in an exhaustive simulation study and an empirical
application using a tactical portfolio of stocks, bonds and a risk-free asset. The results show heterogeneity in portfolio diversification across risk attitudes.

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