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Optimal portfolio choice for higher-order risk averters

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  • Fang, Yi
  • Post, Thierry

Abstract

The effects of higher-order risk aversion on optimal cross-sectional portfolio choice are investigated using portfolio optimization with Stochastic Dominance constraints. Tractable sufficient conditions for higher-degree dominance are introduced that take the form of a system of linear inequalities. Existing studies of active equity industry rotation are extended from lower degrees to higher degrees of dominance. Fourth-degree dominance assumes that investors are ‘prudent’ and ‘temperate’ and therefore like skewness and dislike kurtosis. Using this dominance criterion leads to superior out-of-sample investment performance, by allowing for more concentration in recent winner industries which tend to show persistent positive abnormal returns and a favorable higher-order risk profile due to the industry-level price momentum effect.

Suggested Citation

  • Fang, Yi & Post, Thierry, 2022. "Optimal portfolio choice for higher-order risk averters," Journal of Banking & Finance, Elsevier, vol. 137(C).
    • Handle: RePEc:eee:jbfina:v:137:y:2022:i:c:s0378426622000292
    DOI: 10.1016/j.jbankfin.2022.106429
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    More about this item

    Keywords

    Portfolio choice; Higher-order risk; Portfolio optimization; Linear programming; Active portfolio management;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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