Recently there has been growing interest in applying behavioral finance theory to portfolio investment, especially in the context of international investments across multiple markets and currencies. The key issues mainly involve how to construct optimal portfolios when investors have different risk preferences across different markets, as well as how to manage foreign exchange risk. One paper published in 2020 provided a framework for international portfolio selection using behavioral portfolio theory (BPT) perspective. The model incorporates risk-free assets and exchange rate hedging to focus on preventive savings behaviors of investors. After deriving solutions for single-market case, the paper examines properties of optimal BPT portfolio and aggregate portfolio efficiency across multiple markets. The analysis yields important insights on capital allocation and efficiency loss stemming from investors’ degree of risk aversion. As global investment opportunities continue to grow, insights from behavioral finance can help Chinese investors better construct and optimize their international portfolios.
International BPT Optimal Portfolio Has Exchange Rate Hedging Component
The optimal BPT portfolio has two components – the mean-variance efficient portfolio based on local asset returns, plus an additional component specifically constructed to hedge against exchange rate risk through short positions. The hedging component explains why optimal BPT portfolio may differ from traditional optimizers that ignore currency risk. So investors should not only care about risk-adjusted returns of foreign assets, but also actively manage exposure to exchange rate fluctuations.
Total Portfolio Efficiency Depends on Risk Aversion Degree
When aggregating across different markets, the total portfolio is only mean-variance efficient if returns in different markets are uncorrelated. If not satisfied, efficiency loss emerges from combining single-market optimal portfolios. Notably, such loss depends on degree of risk aversion – extremely risk-averse or risk-seeking investors tend to experience larger losses. So understanding market correlations and investor risk preferences is key for multi-market allocation.
Preventive Savings in Risk-Free Assets Hedge Exchange Rate Risk
The proportion invested in risk-free asset depends on factors like expected foreign returns, exchange rate volatility, and investor risk aversion. When currency risk is higher, more capital flows into risk-free assets to hedge such risk. This demonstrates preventive savings behavior and foreign exchange motives behind asset allocation decisions.
ETFs and Trading Costs Also Affect Portfolio Optimization
In addition to the behavioral portfolio theory framework, the CFA curriculum also covers topics like ETF mechanics & applications and trading costs in electronic markets. These factors interact closely with portfolio construction choices and overall investment efficiency. As an example, ETFs provide various exposures while potentially reducing trading costs.
In summary, the behavioral finance perspective provides important implications on global asset allocation and currency hedging for Chinese investors seeking optimal risk-adjusted returns. By incorporating investor preferences and exchange rate risk spanning multiple markets, techniques like behavioral portfolio theory can lead to better portfolio construction outcomes.