Reward–risk portfolio selection and stochastic dominance |
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| Institution: | 1. Center for Quantitative Economics, Jilin Universityand Business school, Jilin University, Changchun 130012, China;2. Thierry Post is Professor of Finance at the Graduate School of Business of Nazarbayev University, Astana 010000, Kazakhstan;1. Anglia Ruskin IT Research Institute, Faculty of Science and Technology, Anglia Ruskin University, Chelmsford, Essex CM11SQ, UK;2. The Automated Scheduling, Optimisation and Planning (ASAP) Group, School of Computer Science, The University of Nottingham, Nottingham NG8 1BB, UK;3. Nottingham University Business School, The University of Nottingham, Nottingham NG8 1BB, UK;1. School of Finance and China Financial Policy Research Center, Renmin University of China, Beijing, China;2. Center for Applied Statistics, School of Statistics, Renmin University of China, Beijing 100872, China |
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| Abstract: | The portfolio selection problem is traditionally modelled by two different approaches. The first one is based on an axiomatic model of risk-averse preferences, where decision makers are assumed to possess a utility function and the portfolio choice consists in maximizing the expected utility over the set of feasible portfolios. The second approach, first proposed by Markowitz is very intuitive and reduces the portfolio choice to a set of two criteria, reward and risk, with possible tradeoff analysis. Usually the reward–risk model is not consistent with the first approach, even when the decision is independent from the specific form of the risk-averse expected utility function, i.e. when one investment dominates another one by second-order stochastic dominance. In this paper we generalize the reward–risk model for portfolio selection. We define reward measures and risk measures by giving a set of properties these measures should satisfy. One of these properties will be the consistency with second-order stochastic dominance, to obtain a link with the expected utility portfolio selection. We characterize reward and risk measures and we discuss the implication for portfolio selection. |
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