Rational distorted beliefs investor; which risk matters?

This paper considers a portfolio strategy in which the investor applies beliefs distortion to allocate different weights to different kinds of risk in the context of Markovitz portfolio. We assume that the investor decomposes the aggregate risk into three different components:fundamental observed factors’ risk, fundamental non-observed factors’ risk and idiosyncratic risk. Our distorted beliefs’ portfolio outperforms the traditional mean–variance and the naive portfolios. We also find that the rational investor prefers to bear more observed fundamental risk and minimize other risks. •A rational investor does not exhibit the same degree of risk aversion to different kinds of risk.•A rational investor is keen to eliminate the non-observed fundamental and idiosyncratic risks.•Distorted beliefs strategy leads to a more diversified portfolio and reduce the transaction cost.