Portfolio Construction Based on Stochastic Dominance and Empirical Likelihood

44 Pages Posted: 24 Aug 2016 Last revised: 8 Jan 2018

See all articles by Thierry Post

Thierry Post

Graduate School of Business of Nazarbayev University

Selcuk Karabati

Koc University - College of Administrative Sciences and Economics

Stelios Arvanitis

Athens University of Economics and Business

Date Written: September 26, 2017

Abstract

This study develops a portfolio optimization method based on the Stochastic Dominance (SD) decision criterion and the Empirical Likelihood (EL) estimation method. SD and EL share a distribution-free assumption framework which allows for dynamic and non-Gaussian multivariate return distributions. The SD/EL method can be implemented using a two-stage procedure which first elicits the implied probabilities using Convex Optimization and subsequently constructs the optimal portfolio using Linear Programming. The solution asymptotically dominates the benchmark and optimizes the goal function in probability, for a class of weakly dependent processes. A Monte Carlo simulation experiment illustrates the improvement in estimation precision using a set of conservative moment conditions about common factors in small samples. In an application to equity industry momentum strategies, SD/EL yields important out-of-sample performance improvements relative to heuristic diversification, Mean-Variance optimization, and a simple 'plug-in' approach.

Keywords: Stochastic Dominance, Empirical Likelihood, Portfolio optimization, Momentum strategies

JEL Classification: C61, D81, G11

Suggested Citation

Post, Thierry and Karabati, Selcuk and Arvanitis, Stelios, Portfolio Construction Based on Stochastic Dominance and Empirical Likelihood (September 26, 2017). Available at SSRN: https://ssrn.com/abstract=2827305 or http://dx.doi.org/10.2139/ssrn.2827305

Thierry Post (Contact Author)

Graduate School of Business of Nazarbayev University ( email )

53 Kabanbay Batyra Avenue
Astana, 010000
Kazakhstan

Selcuk Karabati

Koc University - College of Administrative Sciences and Economics ( email )

Rumelifeneri Yolu
College of Administrative Sciences and Economics
Sariyer 34450, Istanbul
Turkey

Stelios Arvanitis

Athens University of Economics and Business ( email )

76 Patission Street
Athens, 104 34
GREECE

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