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Portfolio selection in a two-regime world

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  • Levy, Moshe
  • Kaplanski, Guy

Abstract

Standard mean-variance analysis is based on the assumption of normal return distributions. However, a growing body of literature suggests that the market oscillates between two different regimes – one with low volatility and the other with high volatility. In such a case, even if the return distributions are normal in both regimes, the overall distribution is not – it is a mixture of normals. Mean-variance analysis is inappropriate in this framework, and one must either assume a specific utility function or, alternatively, employ the more general and distribution-free Second degree Stochastic Dominance (SSD) criterion. This paper develops the SSD rule for the case of mixed normals: the SSDMN rule. This rule is a generalization the mean-variance rule. The cost of ignoring regimes and assuming normality when the distributions are actually mixed normal can be quite substantial – it is typically equivalent to an annual rate of return of 2–3 percent.

Suggested Citation

  • Levy, Moshe & Kaplanski, Guy, 2015. "Portfolio selection in a two-regime world," European Journal of Operational Research, Elsevier, vol. 242(2), pages 514-524.
    • Handle: RePEc:eee:ejores:v:242:y:2015:i:2:p:514-524
    DOI: 10.1016/j.ejor.2014.10.012
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    1. Bo, Lijun & Tang, Dan & Wang, Yongjin, 2017. "Optimal investment of variance-swaps in jump-diffusion market with regime-switching," Journal of Economic Dynamics and Control, Elsevier, vol. 83(C), pages 175-197.
    2. Platanakis, Emmanouil & Sakkas, Athanasios & Sutcliffe, Charles, 2019. "Harmful diversification: Evidence from alternative investments," The British Accounting Review, Elsevier, vol. 51(1), pages 1-23.
    3. Emmanouil Platanakis & Athanasios Sakkas & Charles Sutcliffe, 2017. "Should Portfolio Model Inputs Be Estimated Using One or Two Economic Regimes?," ICMA Centre Discussion Papers in Finance icma-dp2017-07, Henley Business School, Reading University.
    4. Uddin, Ajim & Yu, Dantong, 2020. "Latent factor model for asset pricing," Journal of Behavioral and Experimental Finance, Elsevier, vol. 27(C).
    5. Haas, Markus, 2016. "A note on optimal portfolios under regime–switching," Finance Research Letters, Elsevier, vol. 19(C), pages 209-216.
    6. Xi Chen & Zhiping Fan & Zhiwu Li & Xueliang Han & Xiao Zhang & Haochen Jia, 2015. "A two-stage method for member selection of emergency medical service," Journal of Combinatorial Optimization, Springer, vol. 30(4), pages 871-891, November.
    7. Pedro Correia S. Bezerra & Pedro Henrique M. Albuquerque, 2017. "Volatility forecasting via SVR–GARCH with mixture of Gaussian kernels," Computational Management Science, Springer, vol. 14(2), pages 179-196, April.

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