Optimal Portfolio Selection with a Shortfall Probability Constraint: Evidence from Alternative Distribution Functions
39 Pages Posted: 22 Jan 2010 Last revised: 7 Feb 2010
Date Written: January 20, 2010
We propose a new approach to optimal portfolio selection in a downside risk framework that allocates assets by maximizing expected return subject to a shortfall probability constraint, reflecting the typical desire of a risk-averse investor to limit the maximum likely loss. Our empirical results indicate that the loss-averse portfolio outperforms the widely-used mean-variance approach based on the cumulative cash values, geometric mean returns, and average risk-adjusted returns. We also evaluate the relative performance of the loss-averse portfolio with normal, symmetric thin-tailed, symmetric fat-tailed, and skewed fat-tailed return distributions in terms of average return, average risk, and average risk-adjusted return.
Keywords: portfolio allocation, kurtosis, skewness
JEL Classification: G12, C13, C22
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