Reward-risk Portfolio Selection and Stochastic Dominance
Enrico G. De Giorgi
University of St. Gallen - SEPS: Economics and Political Sciences
Journal of Banking and Finance, Vol. 29, pp. 895-926, 2005
The portfolio selection problem is traditionally modelled by two different approaches. The first one is based on an axiomatic model of risk-averse preferences, where decision makers are assumed to possess a utility function and the portfolio choice consists in maximizing the expected utility over the set of feasible portfolios. The second approach, first proposed by Markowitz is very intuitive and reduces the portfolio choice to a set of two criteria, reward and risk, with possible tradeoff analysis. Usually the reward-risk model is not consistent with the first approach, even when the decision is independent from the specific form of the riskaverse expected utility function, i.e. when one investment dominates another one by second order stochastic dominance. In this paper we generalize the reward-risk model for portfolio selection. We define reward measures and risk measures by giving a set of properties these measures should satisfy. One of these properties will be the consistency with second-order stochastic dominance, to obtain a link with the expected utility portfolio selection. We characterize reward and risk measures and we discuss the implication for portfolio selection.
Keywords: Stochastic dominance, coherent risk measure, decision under risk, mean-risk models, portfolio optimizatio
JEL Classification: G11, D81Accepted Paper Series
Date posted: May 19, 2005
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