TRACKING ERRORS, REGRET, AND TACTICAL ASSET ALLOCATION

The authors argue that optimization with respect to tracking errors is rooted in a framework where investors are averse to the pain of regret. Regret comes when decisions to deviate from the benchmark turn out badly. Tactical asset allocation involves deviations from a benchmark portfolio and therefore may lead to regret. The authors show how tactical asset allocators can optimize allocations given the conflicting desires to maximize positive tracking errors and minimize regret.