Abstract
This paper considers a portfolio strategy in which the investor applies beliefs distortion to allocate different weights to different kinds of risk in the context of Markovitz portfolio. We assume that the investor decomposes the aggregate risk into three different components:fundamental observed factors’ risk, fundamental non-observed factors’ risk and idiosyncratic risk. Our distorted beliefs’ portfolio outperforms the traditional mean–variance and the naive portfolios. We also find that the rational investor prefers to bear more observed fundamental risk and minimize other risks.
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