General Linear Formulations of Stochastic Dominance Criteria: With an Analysis of Stock Market Portfolio Efficiency
29 Pages Posted: 4 Feb 2012 Last revised: 15 May 2018
Date Written: February 2, 2012
We develop and implement linear formulations of general N-th order Stochastic Dominance criteria for discrete probability distributions. Our approach is based on a piece-wise polynomial representation of utility and its derivatives and can be implemented by solving a relatively small system of linear inequalities. This approach allows for comparing a given prospect with a discrete set of alternative prospects as well as for comparison with a polyhedral set of linear combinations of prospects. We also derive a linear dual formulation in terms of lower partial moments and co-lower partial moments. An empirical application to historical stock market data suggests that the passive stock market portfolio is highly inefficient relative to actively managed portfolios for all investment horizons and for nearly all investors. The results also illustrate that the mean-variance rule and second-order stochastic dominance rule may not detect market portfolio inefficiency because of non-trivial violations of non-satiation and prudence.
Keywords: Stochastic dominance, utility theory, non-satiation, risk aversion, prudence, temperance, linear programming, mean-variance analysis, market portfolio efficiency, lower partial moments
JEL Classification: C22, C32, D81, G11, G12
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