Portfolio Selection with Active Risk Monitoring

39 Pages Posted: 12 Jun 2015

See all articles by Marc S. Paolella

Marc S. Paolella

University of Zurich - Department of Banking and Finance; Swiss Finance Institute

Pawel Polak

University of Zurich; Ecole Polytechnique Fédérale de Lausanne - Ecole Polytechnique Fédérale de Lausanne

Date Written: June 6, 2015

Abstract

The paper proposes a framework for large-scale portfolio optimization which accounts for all the major stylized facts of multivariate financial returns, including volatility clustering, dynamics in the dependency structure, asymmetry, heavy tails, and nonellipticity. It introduces a so-called risk fear portfolio strategy which combines portfolio optimization with active risk monitoring. The former selects optimal portfolio weights. The later, independently, initiates market exit in case of excessive risks. The strategy agrees with the stylized fact of stock market major sell-offs during the initial stage of market downturns. The advantages of the new framework are illustrated with an extensive empirical study. It leads to superior multivariate density and Value-at-Risk forecasting, and better portfolio performance. The proposed risk fear portfolio strategy outperforms various competing types of optimal portfolios, even in the presence of conservative transaction costs and frequent rebalancing. The risk monitoring of the optimal portfolio can serve as an early warning system against large market risks. In particular, the new strategy avoids all the losses during the 2008 financial crisis, and it profits from the subsequent market recovery.

Keywords: COMFORT; Financial Crises; Portfolio Optimization; Risk Monitoring.

JEL Classification: C51; C53; C58; G11; G17.

Suggested Citation

Paolella, Marc S. and Polak, Pawel, Portfolio Selection with Active Risk Monitoring (June 6, 2015). Swiss Finance Institute Research Paper No. 15-17. Available at SSRN: https://ssrn.com/abstract=2616284 or http://dx.doi.org/10.2139/ssrn.2616284

Marc S. Paolella (Contact Author)

University of Zurich - Department of Banking and Finance

Plattenstr. 14
Zürich, 8032
Switzerland

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Pawel Polak

University of Zurich ( email )

Rämistrasse 71
Zürich, CH-8006
Switzerland

Ecole Polytechnique Fédérale de Lausanne - Ecole Polytechnique Fédérale de Lausanne ( email )

c/o University of Geneve
40, Bd du Pont-d'Arve
1211 Geneva, CH-6900
Switzerland

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