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An alternative strategy for balancing profit maximization and risk reduction

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  • Youssef El Khatib
  • Farangiz Mukhamedova

Abstract

Portfolio diversification is a central theme in modern investment theory. We revisit the classic return–risk trade-off and propose an alternative objective Qλ(w)=μ⊤w+λ(w⊤Σw)−1/2 that balances higher expected returns with a direct penalty on portfolio volatility via the inverse standard deviation. This objective belongs to the axiomatic class of mean–variance preferences (as formalised by [1] for additively separable forms) and admits tractable solutions, including a closed-form characterisation in the two-asset case. In rolling out-of-sample backtests on standard Fama–French equity portfolios with realistic trading costs and long-only constraints, Qλ delivers statistically significantly lower realised volatility (paired t-test p

Suggested Citation

  • Youssef El Khatib & Farangiz Mukhamedova, 2026. "An alternative strategy for balancing profit maximization and risk reduction," PLOS ONE, Public Library of Science, vol. 21(5), pages 1-21, May.
    • Handle: RePEc:plo:pone00:0348577
    DOI: 10.1371/journal.pone.0348577
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    References listed on IDEAS

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    1. Victor DeMiguel & Lorenzo Garlappi & Raman Uppal, 2009. "Optimal Versus Naive Diversification: How Inefficient is the 1-N Portfolio Strategy?," The Review of Financial Studies, Society for Financial Studies, vol. 22(5), pages 1915-1953, May.
    2. Bruce N. Lehmann & David M. Modest, 2003. "Diversification and the Optimal Construction of Basis Portfolios," NBER Working Papers 9461, National Bureau of Economic Research, Inc.
    3. Campbell, John Y. & Viceira, Luis M., 2002. "Strategic Asset Allocation: Portfolio Choice for Long-Term Investors," OUP Catalogue, Oxford University Press, number 9780198296942.
    4. Zulia Gubaydullina & Markus Spiwoks, 2009. "Portfolio diversification: an experimental study," Departmental Discussion Papers 140, University of Goettingen, Department of Economics.
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