Portfolio Selection in a Two-Regime World
European Journal of Operational Research, volume 242, (2015), 514-524
33 Pages Posted: 7 May 2016
Date Written: January 5, 2015
Standard mean-variance analysis is based on the assumption of normal return distributions. However, a growing body of literature suggests that the market oscillates between two different regimes – one with low volatility and the other with high volatility. In such a case, even if the return distributions are normal in both regimes, the overall distribution is not – it is a mixture of normals. Mean-variance analysis is inappropriate in this framework, and one must either assume a specific utility function or, alternatively, employ the more general and distribution-free Second degree Stochastic Dominance (SSD) criterion. This paper develops the SSD rule for the case of Mixed Normals: the SSDMN rule. This rule is a generalization the mean-variance rule. The cost of ignoring regimes and assuming normality when the distributions are actually mixed normal can be quite substantial – it is typically equivalent to an annual rate of return of 2%-3%.
Keywords: Regimes, stochastic dominance, mean-variance, portfolio selection
JEL Classification: C44, D81, G11
Suggested Citation: Suggested Citation