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Mean-variance portfolio optimization based on ordinal information

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  • Çela, Eranda
  • Hafner, Stephan
  • Mestel, Roland
  • Pferschy, Ulrich

Abstract

We propose a new approach to integrate qualitative views, in particular ordering relations among expected asset returns, in the well-known Black-Litterman (BL) framework. We assume investor views to be stochastic and adapt the BL-formula for the posterior expectation of asset returns, conditioned on ordering information. The new estimator is computed by applying an importance sampling technique. Using data from the EUROSTOXX 50 and the S&P 100, respectively, we empirically evaluate the forecast quality of our new approach in comparison to existing, but methodologically different, approaches from the literature and assess the performance of our model in a mean-variance portfolio context. We find that our approach mostly achieves the highest predictive power, irrespective of the dataset, the assumed level of accuracy of the ordering information, and mostly irrespective of the investor’s confidence in the qualitative view, even though the improvement resulting from our approach is moderate. We observe a similar behaviour in the context of portfolio performance analysis.

Suggested Citation

  • Çela, Eranda & Hafner, Stephan & Mestel, Roland & Pferschy, Ulrich, 2021. "Mean-variance portfolio optimization based on ordinal information," Journal of Banking & Finance, Elsevier, vol. 122(C).
  • Handle: RePEc:eee:jbfina:v:122:y:2021:i:c:s037842662030251x
    DOI: 10.1016/j.jbankfin.2020.105989
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    References listed on IDEAS

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    6. Chiarawongse, Anant & Kiatsupaibul, Seksan & Tirapat, Sunti & Roy, Benjamin Van, 2012. "Portfolio selection with qualitative input," Journal of Banking & Finance, Elsevier, vol. 36(2), pages 489-496.
    7. Andi Duqi & Leonardo Franci & Giuseppe Torluccio, 2014. "The Black-Litterman model: the definition of views based on volatility forecasts," Applied Financial Economics, Taylor & Francis Journals, vol. 24(19), pages 1285-1296, October.
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    More about this item

    Keywords

    Return estimation; Qualitative views; Black-Litterman model; Portfolio optimization;
    All these keywords.

    JEL classification:

    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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