Regret Aversion, Two-Fund Separation and Optimal Assets Allocation Model

The essential behavior of an investor will influence his financial activities. Regret aversion is a well-established psychological theory that suggests investors may feel regret and disappointed when they find out that their decisions turn out to be wrong. This paper establishes a new utility function based on regret aversion. The new function is not only the function of final wealth but also the function of the ex-post optimal level of final wealth. Then the paper considers the regret aversion in asset allocation model of an investor. It is also found that the optimal assets allocation model based on regret aversion generates two-fund separation. Finally the paper takes empirical studies in Shanghai stock market and obtains portfolio frontiers of the new model. Also the conclusion that the model generates two-fund separation is testified.