Coherent Asset Allocation and Diversification in the Presence of Stress Events

Journal of Investment Management, 10, 4, 2012

36 Pages Posted: 28 Apr 2011 Last revised: 6 May 2013

Date Written: April 27, 2011

Abstract

We propose a method to integrate frequentist and subjective probabilities in order to obtain a coherent asset allocation in the presence of stress events. Our working assumption is that in normal market asset returns are sufficiently regular for frequentist statistical techniques to identify their joint distribution, once the outliers have been removed from the data set. We also argue, however, that the exceptional events facing the portfolio manager at any point in time are specific to the each individual crisis, and that past regularities cannot be relied upon. We therefore deal with exceptional returns by eliciting subjective probabilities, and by employing the Bayesian net technology to ensure logical consistency. The portfolio allocation is then obtained by utility maximization over the combined (normal plus exceptional) distribution of returns. We show the procedure in detail in a stylized case.

Suggested Citation

Rebonato, Riccardo and Denev, Alexander, Coherent Asset Allocation and Diversification in the Presence of Stress Events (April 27, 2011). Journal of Investment Management, 10, 4, 2012, Available at SSRN: https://ssrn.com/abstract=1824207 or http://dx.doi.org/10.2139/ssrn.1824207

Riccardo Rebonato

Royal Bank of Scotland ( email )

Alexander Denev (Contact Author)

University of Oxford ( email )

Mansfield Road
Oxford, Oxfordshire OX1 4AU
United Kingdom

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