Skew and Trend Aversion: The Impact of Positive Skew and Behavioral Biases on Allocation Decisions

Abstract

Despite overwhelming evidence of the portfolio benefits, actual investor allocations to trend following strategies are typically 5% or less. Why is there such a significant discrepancy between the optimal allocation and actual allocation to Trend? The authors investigate known behavioral biases as a potential reason. In this article, the authors explore loss aversion, recency bias, and the ambiguity effect as they pertain to trend following, and define the combination of the three trend aversion. The authors quantify trend aversion and show that these biases are a viable explanation for suboptimal allocations to Trend. The authors demonstrate a direct connection between quantifications of known behavioral biases and current suboptimal allocations to trend following. Recognition of this relationship will help allocators make better decisions and construct more robust portfolios.

TOPICS: Analysis of individual factors/risk premia, risk management, wealth management, performance measurement, technical analysis

Key Findings

• • We quantify behavioral biases and show they are a viable explanation for sub-optimal allocations to trend following.

• • The quantitative levels of loss aversion necessary to justify typical allocations to trend following are consistent with psychological studies.

• • The combination of loss aversion and recency bias is particularly impactful on trend following because of its positive skew.