With the arrival of the ill-fitting Capital Market Line onto the efficient frontier, that eternal Achilles heel of portfolio selection, the moment when the analyst has to go back to the investor and asks them where they prefer to be on the efficient frontier reappears as a question of where the investor ought to be on the Capital Market Line. Markowitz had always been comfortable, having been taught by the Bayesian Jimmy Savage, with considering the expected returns and covariances as a modellable step. Soon to come was Fama, telling the world that, at least up to that point, the observed price history of the security was the best model of stock returns, which somewhat distracted the intellectual impetus from producing a proper Bayesian framework, as per Black and Litterman.
However, I think even the self-estimate on how risk adverse the investor was could perhaps have been re calibrated as a decision, not a preference. Making it a decision allows the tools of decision theory to be making suggestions here. Rather like the potential claimed benefits of traffic smoothing, low insurance, low accident rates, fewer cars in a world of driverless cars.
When an investor is asked for his preference I presume he in effect is really making some kind of unspoken decision either then, or at some point in the past. And after all, how stable, how low a variance, is attached to the investor's risk appetite. Using words like 'appetite' make it sound like Keynes's 'animal spirits' inside the hearts of those people who make business investment decisions. If there's in principle the idea of varying appetites, which of course lies behind the final stage of classic Markowitzian portfolio selection, then how rational can that set of disparate appetites be?
Asking the question opens the Pandora's box. That same box which remains closed in other realms of seeming human freedom - the law, consumption of goods.
Here's my initial stab at offering a model which demonstrates simultaneously multiple appetites but with retaining an element of rationality. That's not to say that a behavioural scientist can't spot irrational decisions in practice. Rather like CAPM, this attempt to remain rational might provide an interesting theoretical framework.
Aged 90, if we're lucky, on our death bed, we don't need to worry too much any more about our future investments. Clearly, the older you are, the more you can afford to backslide down the CLM towards the $R_f$ point, ceteris paribus. Conversely the more your expected lifetime consumption is ahead of you, the more you'd be tempted to inch up the CML.
Trying to take each element separately is difficult since there are clearly relationships between them. Element two is wealth. Clearly the average person becomes wealthier the older they get. But, assuming a more or less stable spending pattern, it could be argued (billionaires aside) that as wealth increases, the investor relaxes back down the CML.
Both these first two elements are in a loose sense endogenous; the third element, such that it can be known, would be exogenous - if you have a model which tells you how likely it is that there's going to be a recession, then that could drive you up and down the CML.
Perhaps what's needed is an overrideable automation switch for where the investor resides on the CML right now. That is, a personalisation process which guides the investor, which demonstrates to the investor how they deviate from the average CML lifetime journey.
Element four could be mark to market performance. Say the investor has a short term institutional hurdle to overcome, e.g. they would be happy making 10% each year. I.e. that they're not just maximising lifetime expected wealth but have equally important short term goals. Let's say we count a year as running from October to September and the investor achieved 10% by April one year. Perhaps he'd be content to step away from the volatility from April to September one year. By asking an investor what their risk appetite is, you're already asking them to accept a non market return, since only those investors who stick stubbornly to the tangency portfolio will see this. Most investors will spend most of their investment life somewhere between $R_f$ and M, probably closer to M. So they will have accepted a lower expected return anyway. Some portfolio managers and hedge fund managers already run their businesses akin to this - they have perhaps loose monthly or quarterly targets and will step off the gas deliberately on occasion on good periods. Converse they might increase leverage disastrously if they feel they're in catch up, a move often described as doubling down after the famous Martingale betting strategy.
The argument against element three above is as follows: first, many hedge funds have tried to beat the market. Not many consistently do, and even less so do it for macro economic reasons. No such an exogenous model could be built. To its advantage would be the fact that this model trades only in highly liquid assets (e.g. e-minis and treasury bills) so this would reduce transaction costs. Secondly, transaction costs these days can be built in as a constraint to the portfolio optimisation step. Another point in its favour is that the economic model can be made to generate actionable signals at a very coarse level. A counter-cyclical model, which pushes you up the CML when a recession has occurred, would be a first step (running the risk of all such portfolio insurances of the past); a second step would be a model which slightly accelerates the back sliding only after the period of economic expansion is well beyond the normal range of duration for economic expansions. This second step in effect relies on there being some form of stability to the shape and duration of the credit cycle.
Leaving the investor's risk preferences as an unopened black box seems to be missing a trick.
