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Authors / Editors
Basak S; Makarov D
This paper develops a tractable dynamic model of competition between two risk-averse portfolio managers who attempt to outperform each other. To capture asset specialization, we consider two imperfectly correlated risky stocks whereby each manager trades in one of the stocks. We characterize explicitly the unique Nash equilibrium portfolio policies, and show that competition makes a relatively risk tolerant manager decrease, and a risk intolerant increase, her portfolio risk. Moreover, a higher own risk aversion may induce a manager to take more risk, contrary to the standard prediction in the absence of competition. We also show that competition can be conducive to asset specialization, in that both managers, when relatively risk tolerant, can voluntarily opt for asset specialization and the corresponding loss of diversification to avoid competing on the same turf by trading in the same set of stocks. Considering a client investor of a manager, we find that her preferences for or against asset specialization could well be the opposite to that of her manager. Finally, we examine the client’s costs arising as managerial turnover or changing stock characteristics misaligns the client manager’s policy. The client loses more when it is her manager who is replaced than the other manager, whereas her losses are the same for a given change in her manager’s stock characteristics as for that in the competitor manager’s stock.
Competition, Portfolio Choice, Asset Specialization, Relative Performance, Cost-Benefit Analysis