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Mean-variance vs. full-scale optimization: broad evidence for the U.K

Author

Listed:
  • Richard G. Anderson
  • Jane M. Binner
  • Thomas Elger
  • Björn Hagströmer
  • Birger Nilsson

Abstract

In the Full-Scale Optimization approach the complete empirical financial return probability distribution is considered, and the utility maximising solution is found through numerical optimization. Earlier studies have shown that this approach is useful for investors following non-linear utility functions (such as bilinear and S-shaped utility) and choosing between highly non-normally distributed assets, such as hedge funds. We clarify the role of (mathematical) smoothness and differentiability of the utility function in the relative performance of FSO among a broad class of utility functions. Using a portfolio choice setting of three common assets (FTSE 100, FTSE 250 and FTSE Emerging Market Index), we identify several utility functions under which Full-Scale Optimization is a substantially better approach than the mean variance approach is. Hence, the robustness of the technique is illustrated with regard to asset type as well as to utility function specification.

Suggested Citation

  • Richard G. Anderson & Jane M. Binner & Thomas Elger & Björn Hagströmer & Birger Nilsson, 2007. "Mean-variance vs. full-scale optimization: broad evidence for the U.K," Working Papers 2007-016, Federal Reserve Bank of St. Louis.
    • Handle: RePEc:fip:fedlwp:2007-016
    DOI: 10.20955/wp.2007.016
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    Cited by:

    1. de Farias Neto, Joao Jose, 2008. "S-shaped utility, subprime crash and the black swan," MPRA Paper 12122, University Library of Munich, Germany.
    2. David Johnstone & Dennis Lindley, 2013. "Mean-Variance and Expected Utility: The Borch Paradox," Papers 1306.2728, arXiv.org.
    3. Michael J. Best & Xili Zhang, 2011. "Degeneracy Resolution for Bilinear Utility Functions," Journal of Optimization Theory and Applications, Springer, vol. 150(3), pages 615-634, September.
    4. George Yungchih Wang, 2012. "Evaluating an Investment Project in an Incomplete Market," The Review of Finance and Banking, Academia de Studii Economice din Bucuresti, Romania / Facultatea de Finante, Asigurari, Banci si Burse de Valori / Catedra de Finante, vol. 4(1), pages 055-073, June.

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    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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