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

Author

Listed:
  • Thierry Post

    (Koç University, Graduate School of Business)

  • Milos Kopa

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

Abstract

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.

Suggested Citation

  • Thierry Post & Milos Kopa, 2015. "Portfolio Choice based on Third-degree Stochastic Dominance, With an Application to Industry Momentum," Koç University-TUSIAD Economic Research Forum Working Papers 1527, Koc University-TUSIAD Economic Research Forum.
    • Handle: RePEc:koc:wpaper:1527
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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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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Portfolio choice; Stochastic dominance; Semi-variance; Quadratic programming; Enhanced indexing; Industry momentum.;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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