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Portfolio Choice Based on Third-Degree Stochastic Dominance

Author

Listed:
  • Thierry Post

    (Graduate School of Business, Koç University, 34450 Istanbul, Turkey)

  • Miloš Kopa

    (Faculty of Mathematics and Physics, Department of Probability and Mathematical Statistics, Charles University, 186 75 Prague 8, Prague, Czech Republic)

Abstract

We develop an optimization method for constructing investment portfolios that dominate a given benchmark portfolio in terms of third-degree stochastic dominance. Our approach relies on the properties of the semivariance function, a refinement of an existing “superconvex” dominance condition, and quadratic constrained programming. 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 Center for Research in Security Prices all-share index, 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.

Suggested Citation

  • Thierry Post & Miloš Kopa, 2017. "Portfolio Choice Based on Third-Degree Stochastic Dominance," Management Science, INFORMS, vol. 63(10), pages 3381-3392, October.
    • Handle: RePEc:inm:ormnsc:v:63:y:2017:i:10:p:3381-3392
    DOI: 10.1287/mnsc.2016.2506
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    References listed on IDEAS

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