Not all asset decisions fit neatly into the traditional risk–return paradigm of portfolio selection. For example, investors may wish to include in their portfolios a minimum percentage representation, or an absolute dollar amount, of socially conscious firms. The author presents an alternative to the traditional technique and illustrates it using gold as a comfort asset as applied to a portfolio of foreign currency–denominated securities.
Many investors want to add a minimum percentage of an asset to their portfolios because they are comforted by that asset. It is possible that this asset may not be appropriate according to the traditional risk–return framework of portfolio selection. The author uses gold as an example of such an asset; it is a common destination of investors’ “flight to quality.” The technique the author develops carries over directly to such other assets as environmentally or socially responsible firms. The author presents and illustrates an enhanced portfolio selection framework aimed at better incorporation of so-called comfort assets into a portfolio.
How Is This Research Useful to Practitioners?
The ultimate goal of portfolio management is to find the optimal mix that will maximize the investor’s utility of regular assets and the comfort asset. The author incorporates a framework for portfolio optimization that recognizes an asset that provides investors with utility that is separate from traditional risk and return. The portfolio’s optimal weights can be calculated by taking into account the combination of the investor’s degree of risk aversion and attraction to the “comfort asset.”
How Did the Author Conduct This Research?
The author starts with the traditional portfolio optimization methodology for a portfolio of foreign currency–denominated securities, including gold. In the traditional model, the investor seeks to maximize utility, which is a function of the portfolio’s expected return and the investor’s degree of risk aversion. As aversion to risk increases (i.e., as an investor becomes more willing to trade off expected return for less risk), the foreign portfolio weight increases.
To measure the amount of expected return the investor is willing to give up at the margin in exchange for comfort, the author creates a “discomfort index” and introduces gold as an offsetting “comfort asset.” Gold is recognized both as an asset that presents an imperfect correlation with the foreign currency and as a comfort provider.
Gold can alleviate discomfort in a portfolio in variety of ways. Inflation decreases the purchasing power of the paper currency. Gold serves as a haven from the effects of inflation and becomes more attractive when paper assets exhibit greater volatility. The author incorporates the “comfort asset” via a simple variation in the traditional risk–return equation. The investor seeks to maximize utility considering three elements: risk, return, and comfort. An increase in the investor’s desire for comfort shifts the exposure to the foreign portfolio downward and the exposure to gold upward.
Portfolio managers are constantly faced with situations in which investors want to add assets to their portfolios because those assets make them “happy.” Investors have many reasons to include assets in their portfolios that do not fit into an optimal mean–variance framework (e.g., the assets are socially conscious or environmentally friendly). The approach the author develops allows investors to make the optimal asset allocation decision while including “comfort assets” in their portfolios. He uses gold as an example of a comfort asset to develop the model. The investor in the framework, recognizing gold as both a currency diversifier and “desired asset,” chooses the optimal asset allocation (including currency hedging) independent of gold’s expected return, risk, and correlation with other assets. This procedure can be applied to any asset class that the investor finds comfort in.