Downside risk and asset pricing |
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| Institution: | 1. Department of Finance, National Kaohsiung First University of Science and Technology, Taiwan;2. Department of Finance, National Sun Yat-sen University, Taiwan;3. Department of Finance, Tainan University of Technology, Taiwan;1. Faculty of Business and Economics, University of Lausanne, 1015 Lausanne, Switzerland;2. Swiss Finance Institute, Boulevard du Pont-d’Arve 40, Genève 1205, Switzerland;3. School of Economics, Shandong University, Jinan, Shandong, China;4. School of Finance, Shanghai University of Finance and Economics, Shanghai, China;5. Shanghai Institute of International Finance and Economics, Shanghai, China |
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| Abstract: | We analyze if the value-weighted stock market portfolio is stochastic dominance (SD) efficient relative to benchmark portfolios formed on size, value, and momentum. In the process, we also develop several methodological improvements to the existing tests for SD efficiency. Interestingly, the market portfolio seems third-order SD (TSD) efficient relative to all benchmark sets. By contrast, the market portfolio is inefficient if we replace the TSD criterion with the traditional mean–variance criterion. Combined these results suggest that the mean–variance inefficiency of the market portfolio is caused by the omission of return moments other than variance. Especially downside risk seems to be important for explaining the high average returns of small/value/winner stocks. |
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