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Deep Portfolio Theory

Author

Listed:
  • J. B. Heaton
  • N. G. Polson
  • J. H. Witte

Abstract

We construct a deep portfolio theory. By building on Markowitz's classic risk-return trade-off, we develop a self-contained four-step routine of encode, calibrate, validate and verify to formulate an automated and general portfolio selection process. At the heart of our algorithm are deep hierarchical compositions of portfolios constructed in the encoding step. The calibration step then provides multivariate payouts in the form of deep hierarchical portfolios that are designed to target a variety of objective functions. The validate step trades-off the amount of regularization used in the encode and calibrate steps. The verification step uses a cross validation approach to trace out an ex post deep portfolio efficient frontier. We demonstrate all four steps of our portfolio theory numerically.

Suggested Citation

  • J. B. Heaton & N. G. Polson & J. H. Witte, 2016. "Deep Portfolio Theory," Papers 1605.07230, arXiv.org, revised Jan 2018.
    • Handle: RePEc:arx:papers:1605.07230
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    References listed on IDEAS

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    1. Rosenberg, Barr & McKibben, Walt, 1973. "The Prediction of Systematic and Specific Risk in Common Stocks," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 8(2), pages 317-333, March.
    2. Stephen A. Ross, 2013. "The Arbitrage Theory of Capital Asset Pricing," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 1, pages 11-30, World Scientific Publishing Co. Pte. Ltd..
    3. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, March.
    4. Chamberlain, Gary & Rothschild, Michael, 1983. "Arbitrage, Factor Structure, and Mean-Variance Analysis on Large Asset Markets," Econometrica, Econometric Society, vol. 51(5), pages 1281-1304, September.
    5. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, September.
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