Smaller drawdowns, higher average and risk-adjusted returns for equity portfolios, using options and power-log optimization based on a behavioral model of investor preferences

Jivendra K. Kale and Tee Lim

Abstract

We use a power-log utility optimization algorithm based on a behavioral model of investor preferences, along with either a call or a put option overlay, to reverse the negative skewness of monthly Standard & Poor’s 500 (S&P 500) index returns and to produce portfolios with smaller drawdowns and far higher risk-adjusted returns than the S&P 500 index. All the optimal portfolios have positively skewed returns, which are preferred by investors. Optimal portfolios containing the call have higher average returns than the S&P 500 index as well as much higher average and risk-adjusted returns than portfolios containing the put, except for the most conservative portfolios.