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Portfolio Choice based on Third-degree Stochastic Dominance, With an Application to Industry Momentum

Listed author(s):
  • Thierry Post

    ()

    (Koç University, Graduate School of Business)

  • Milos Kopa

    ()

    (Charles University Prague, Department of Probability and Mathematical Statistics)

Registered author(s):

    We develop and implement a portfolio optimization method for building investment portfolios that dominate a given benchmark index in terms of third-degree stochastic dominance. Our approach relies on the properties of the semi-variance function, a refinement of an existing 'super-convex' dominance condition and quadratic constrained programming. To reduce the computational burden in large-scale applications, we propose a problem reduction method based on vertex enumeration. We apply our method to historical stock market data using an industry momentum strategy. Our enhanced portfolio generates important performance improvements compared with alternatives based on mean-variance dominance and second-degree stochastic dominance. Relative to the benchmark, our portfolio increases average out-of-sample return by almost seven percentage points per annum without incurring more downside risk, using quarterly rebalancing and without short selling.

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    File URL: http://eaf.ku.edu.tr/sites/eaf.ku.edu.tr/files/erf_wp_1527.pdf
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    Paper provided by Koc University-TUSIAD Economic Research Forum in its series Koç University-TUSIAD Economic Research Forum Working Papers with number 1527.

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    Length: 28 pages
    Date of creation: Dec 2015
    Handle: RePEc:koc:wpaper:1527
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    Web page: http://erf.ku.edu.tr
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    1. Fishburn, Peter C., 1974. "Convex stochastic dominance with continuous distribution functions," Journal of Economic Theory, Elsevier, vol. 7(2), pages 143-158, February.
    2. R. G. Vickson, 1975. "Stochastic Dominance Tests for Decreasing Absolute Risk Aversion. I. Discrete Random Variables," Management Science, INFORMS, vol. 21(12), pages 1438-1446, August.
    3. Roman, Diana & Mitra, Gautam & Zverovich, Victor, 2013. "Enhanced indexation based on second-order stochastic dominance," European Journal of Operational Research, Elsevier, vol. 228(1), pages 273-281.
    4. Clark, Ephraim & Jokung, Octave & Kassimatis, Konstantinos, 2011. "Making inefficient market indices efficient," European Journal of Operational Research, Elsevier, vol. 209(1), pages 83-93, February.
    5. Thierry Post, 2003. "Empirical Tests for Stochastic Dominance Efficiency," Journal of Finance, American Finance Association, vol. 58(5), pages 1905-1932, October.
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    7. James P. Quirk & Rubin Saposnik, 1962. "Admissibility and Measurable Utility Functions," Review of Economic Studies, Oxford University Press, vol. 29(2), pages 140-146.
    8. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
    9. Tobias J. Moskowitz & Mark Grinblatt, 1999. "Do Industries Explain Momentum?," Journal of Finance, American Finance Association, vol. 54(4), pages 1249-1290, 08.
    10. Hadar, Josef & Russell, William R, 1969. "Rules for Ordering Uncertain Prospects," American Economic Review, American Economic Association, vol. 59(1), pages 25-34, March.
    11. Jun-ya Gotoh & Hiroshi Konno, 2000. "Third Degree Stochastic Dominance and Mean-Risk Analysis," Management Science, INFORMS, vol. 46(2), pages 289-301, February.
    12. Bawa, Vijay S., 1975. "Optimal rules for ordering uncertain prospects," Journal of Financial Economics, Elsevier, vol. 2(1), pages 95-121, March.
    13. R. G. Vickson, 1977. "Stochastic Dominance Tests for Decreasing Absolute Risk-Aversion II: General Random Variables," Management Science, INFORMS, vol. 23(5), pages 478-489, January.
    14. James E. Hodder & Jens Carsten Jackwerth & Olga Kolokolova, 2015. "Improved Portfolio Choice Using Second-Order Stochastic Dominance," Review of Finance, European Finance Association, vol. 19(4), pages 1623-1647.
    15. Fama, Eugene F & French, Kenneth R, 1996. " Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, American Finance Association, vol. 51(1), pages 55-84, March.
    16. Antonella Basso & Paolo Pianca, 1997. "Decreasing Absolute Risk Aversion and Option Pricing Bounds," Management Science, INFORMS, vol. 43(2), pages 206-216, February.
    17. Jegadeesh, Narasimhan & Titman, Sheridan, 1993. " Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency," Journal of Finance, American Finance Association, vol. 48(1), pages 65-91, March.
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