Portfolio Choice Based on Third-Degree Stochastic Dominance
31 Pages Posted: 8 Nov 2015 Last revised: 28 Mar 2016
Date Written: March 19, 2016
We develop an optimization method for constructing investment portfolios that dominate a given benchmark index in terms of third-degree stochastic dominance. Our approach relies on the properties of the semivariance function, a refinement of an existing ‘super-convex’ dominance condition and quadratic constrained programming. We apply our method to historical stock market data using an industry momentum strategy. Our enhanced portfolio generates important performance improvements compared with alternatives based on mean-variance dominance and second-degree stochastic dominance. Relative to the CSRP all-share index, our portfolio increases average out-of-sample return by almost seven percentage points per annum without incurring more downside risk, using quarterly rebalancing and without short selling.
Keywords: Portfolio choice, Stochastic dominance, Quadratic programming, Enhanced indexing, Industry momentum
JEL Classification: C61, D81, G11
Suggested Citation: Suggested Citation