A Portfolio Optimality Test Based on the First-Order Stochastic Dominance Criterion

Abstract

Existing approaches to testing for the efficiency of a given portfolio make strong parametric assumptions about investor preferences and return distributions. Stochastic dominance based procedures promise a useful non-parametric alternative. However, these procedures have been limited to considering binary choices.In this paper we consider a new approach that considers all diversified portfolios, and thereby introduce a new concept of first-order stochastic dominance (FSD) optimality of a given portfolio relative to all possible portfolios. Using our new test, we show that the US stock market portfolio is significantly FSD non-optimal relative to benchmark portfolios formed on market capitalization and book-to-market equity ratios. Without appealing to parametric assumptions about the return distribution, we conclude that no nonsatiable investor would hold the market portfolio in the face of the attractive premia of small caps and value stocks.

Keywords: stochastic dominance, optimality, admissibility, portfolio diversification

JEL Classification: D81, G11