Portfolio Choice Based on Third-Degree Stochastic Dominance

31 Pages Posted: 8 Nov 2015 Last revised: 28 Mar 2016

See all articles by Thierry Post

Thierry Post

Graduate School of Business of Nazarbayev University

Milos Kopa

Charles University in Prague - Faculty of Mathematics and Physics

Date Written: March 19, 2016

Abstract

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

Post, Thierry and Kopa, Milos, Portfolio Choice Based on Third-Degree Stochastic Dominance (March 19, 2016). Available at SSRN: https://ssrn.com/abstract=2687104 or http://dx.doi.org/10.2139/ssrn.2687104

Thierry Post (Contact Author)

Graduate School of Business of Nazarbayev University ( email )

53 Kabanbay Batyra Avenue
Astana, 010000
Kazakhstan

Milos Kopa

Charles University in Prague - Faculty of Mathematics and Physics ( email )

Sokolovska 83
Prague, 186 75
Czech Republic

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