Portfolio Optimization Based on Almost Second-Degree Stochastic Dominance
Оптимизация портфеля на основе почти второго порядка стохастического доминирования
2024-11-27
SCID: 54.1/tkz9wde6
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ASSDalmost second-degree stochastic dominancediscretization of return rangeiterative optimization procedureportfolio optimization
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Abstract (AI)
In portfolio optimization, the computational complexity of implementing almost stochastic dominance has limited its practical applications. In this study, we introduce an optimization framework aimed at identifying the optimal portfolio that outperforms a specified benchmark under almost second-degree stochastic dominance (ASSD). Our approach involves discretizing the return range and establishing both sufficient and necessary conditions for ASSD. We then propose a three-step iterative procedure: first, identifying a candidate portfolio; second, assessing its optimality; and third, refining the discretization scheme. Theoretical analysis guarantees that the portfolio identified through this iterative process improves with each iteration, ultimately converging to the optimal solution. Our empirical study, utilizing industry portfolios, demonstrates the efficacy of our approach by consistently identifying an optimal portfolio within a few iterations. Furthermore, comparative analysis against other decision criteria, such as mean-variance, second-degree stochastic dominance, and third-degree stochastic dominance, reveals that ASSD generally leads to portfolios with higher out-of-sample average excess returns but also entails increased variations and risks. This paper was accepted by Agostino Capponi, finance. Funding: C. Luo acknowledges financial support from the National Natural Science Foundation of China [Grant 72101070] and the Zhejiang Provincial Natural Science Foundation of China [Grant LY23G010001]. P. Chen acknowledges financial support from the National Natural Science Foundation of China [Grant 72401253]. P. Jaillet acknowledges financial support from the Office of Naval Research [Grant N00014-18-1-2122 and N00014-24-1-2470] and the Air Force Office of Scientific Research [Grant FA9550-23-1-0182 and Grant FA9550-23-1-0190]. Supplemental Material: The data files are available at https://doi.org/10.1287/mnsc.2022.01092 .
Key Findings
1
Compared to mean-variance, second-degree, and third-degree stochastic dominance criteria, ASSD-based portfolios produce higher out-of-sample average excess returns but exhibit greater variation and risk.
2
Developed discretization of return range and derived sufficient and necessary conditions for ASSD implementation.
3
Empirical tests on industry portfolios show the method typically identifies an optimal portfolio within a few iterations.
4
Introduced an optimization framework to find portfolios that outperform a benchmark under almost second-degree stochastic dominance (ASSD).
5
Proposed a three-step iterative procedure (candidate identification, optimality assessment, discretization refinement) that monotonically improves portfolios each iteration and converges to the optimal solution.
Research Object
Investment portfolio optimized to outperform a specified benchmark under almost second-degree stochastic dominance (ASSD)
Research Subject
Identification and iterative optimization procedure (discretization, candidate selection, optimality assessment, refinement) and performance characterization of portfolios under ASSD, including convergence to the ASSD-optimal portfolio and comparative out-of-sample return/risk trade-offs
Publication Details
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2024-11-27
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