Portfolio Selection in a Two-Regime World

European Journal of Operational Research, volume 242, (2015), 514-524

33 Pages Posted: 7 May 2016

See all articles by Moshe Levy

Moshe Levy

Hebrew University of Jerusalem - Jerusalem School of Business Administration

Guy Kaplanski

Bar-Ilan University - Graduate School of Business Administration

Date Written: January 5, 2015

Abstract

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

Levy, Moshe and Kaplanski, Guy, Portfolio Selection in a Two-Regime World (January 5, 2015). European Journal of Operational Research, volume 242, (2015), 514-524. Available at SSRN: https://ssrn.com/abstract=2775751

Moshe Levy

Hebrew University of Jerusalem - Jerusalem School of Business Administration ( email )

Mount Scopus
Jerusalem, 91905
Israel

Guy Kaplanski (Contact Author)

Bar-Ilan University - Graduate School of Business Administration ( email )

Ramat Gan
Israel

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