Realativity in Finance: Goals and Risk-Based Asset Pricing for Investors with Multiple Stochastic Goals and Agents

Vol. 21, No. 4, 2023
Arun Muralidhar

This asset pricing model incorporates four positive realities of investing; that investors have many stochastic goals, seek to delegate to skillful agents, explicitly specify risk budgets, and maximize risk-adjusted relative returns. As a result, it also incorporates the relative nature of investing—“Realativity”. Critical to investment practice, it provides asset pricing, asset allocations, and risk-adjusted performance measures that are consistent. Assets are priced with just two goal-replicating assets and the absolute risk-free asset. The pair-wise equilibrium model uses observable assets and risk budgets, offers practical asset allocation recommendations, and captures dual attributes of risky assets (i.e., risky asset and hedge for other goals). Furthermore, asset allocation is “view neutral” and does not require expected return forecasts which are notoriously incorrect. It also possibly explains other interesting investment phenomena—e.g., why two pension funds with similar risk budgets could have very different asset allocations or why their expected returns forecasts may differ

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