Other Portfolio

Selection Models
Adapted by Team 2
Introduction
Up to this point we have used the traditional
mean-variance approach to portfolio management;
Investors are utility maximizers
Investors are risk averse
Security returns are normally distributed or utility
functions are quadratic

We will now look at other approaches to the
portfolio problem
Other Portfolio Selection
Models
Other models make less stringent assumptions
about:

The investors choice framework

The form of the utility function

The form of the distribution of security returns

Other Portfolio Selection
Models
Other models include:

The geometric mean return

Safety first

Stochastic dominance

Skewness analysis

Geometric Mean Return Model
Select the portfolio that has the highest expected
geometric mean return

Proponents of the GMR portfolio argue;
Has the highest probability of reaching, or exceeding, any
given wealth level in the shortest period of time

Has the highest probability of exceeding any given wealth
level over any period of time

Opponents argue that expected value of terminal
wealth is not the same as maximizing the utility of
terminal wealth
Properties of the GMR
Portfolio
A diversified portfolio usually has the highest
geometric mean return

A strategy that has a possibility of bankruptcy would
never be selected

The GMR portfolio will generally not be mean-
variance efficient unless;
Investors have a log utility function and returns are
normally or log-normally distributed

Safety First Models
A second alternative to expected utility
theorem: safety first
Says decision makers are unable/unwilling
to go through the mathematics of the
expected utility theorem and will use a
simpler decision model that concentrates on
bad outcomes
Three Safety Criteria
1. Roy: The best portfolio has the smallest
probability of producing a return below
some specified level

Minimize (R
p
< R
L
)
Where R
p
= return on portfolio
R
L
= minimum level to which returns can fall

Three Safety Criteria
If returns are normally distributed, the optimum portfolio
exists when R
L
is the maximum number of standard
deviations away from the mean.

To determine how many standard deviations R
L
lies below
the mean (if returns are normally distributed),
minimize R
L
R
p

p

The portfolio that maximizes Roys criterion must lie
along the efficient frontier in mean standard deviation
space.
Three Safety Criteria
The use of Tchebyshevs inequality
produces similar results, same maximization
problem
Gives an expression that allows the
determination of the maximum odds of
obtaining a return less than some number
Makes very weak assumptions about the
underlying distribution
Three Safety Criteria
2. Kataoka: Maximize the lower limit subject to the
constraint that the probability of a return less than
or equal to the lower limit is not greater than some
predetermined value
Maximize R
L
Subject to Prob(R
p
< R
L
)
or R
L
R
p
(constant)
p

Tchebyshevs inequality produces same results as
normally distributed returns


Three Safety Criteria
3. Telser: An investor maximizes expected return, subject to
the constraint that the probability of a return less than or
equal to some predetermined limit is not greater than some
predetermined number

Maximize R
p
Subject to Prob(R
p
R
L
)
or R
L
R
p
(constant)

The optimum portfolio lies in the efficient frontier in mean
standard deviation space or does not exist
Tchebyshevs inequality produces same results
Three Safety Criteria
Under reasonable assumptions, safety
criteria lead to mean-variance analysis and
to the selection of a portfolio in the efficient
set
With unlimited lending and borrowing at
risk-free rate, the analysis may lead to
infinite borrowing
Possible problem with assumption that
investors can borrow unlimited amounts at risk-
free rate
Stochastic Dominance
Another alternative to mean variance
analysis
Define efficient sets under alternative
assumptions about general characteristics of
investors utility function
Three stronger assumptions
First Order: non-satiation
Second Order: risk averse (includes first)
Third Order: decreasing absolute risk aversion
(includes previous two)
Idea behind First-Order
Dominance
Formal Theorem: If investors prefer more
to less, and if the cumulative probability of
A is never greater than the cumulative
probability of B and sometimes less, then A
is preferred to B.
Second-Order
If the two curves cross, a choice is not
possible
Therefore, we have to make the second
assumption (Risk Aversion)
Investor must be compensated for bearing risk
Decreasing marginal utility

Idea behind Second-Order
Formal Thm: If investors prefer more to
less, are risk averse, and the sum of the
cumulative probabilities for all returns are
never more with A than B and sometimes
less, then A dominates B with second order
stochastic dominance.
How does this relate to mean-
variance analysis?
If returns are normally distributed and short
sales are allowed
Preferring higher mean for any standard
deviation leads to efficient frontier
No short sales
First order produces a set of portfolios that lie
on upper half of outer boundary of the feasible
set
This includes efficient set produced by mean-
variance analysis
Relating Cont
Second-order assumptions also lead to the
efficient set theorem
Thus, with normal returns, the only set of
portfolios that is not dominated, using second
order, is the mean-variance efficient set
Advantage of Stochastic
Dominance
Used to derive sets of desirable portfolios
when returns are not normal or when the
investor is unwilling to assume specific
utility functions
But direct use is infeasible
Infinite set of alternatives in portfolio selection
Third-Order
Assumes decreasing absolute risk aversion
Function exhibiting this is positive third
derivative
Thm: If the theorem for second order holds
true, plus if the third derivative of the
investors utility function is positive and the
mean of A is greater than the mean of B,
then A dominates B.
Skewness and Portfolio Analysis
The third moment
SKEWNESS
What is it?
Skewness measures the asymmetry of a
distribution
A Normal Distribution has a skewness of???
ZERO
Empirical evidence indicates that investors actually have
positive skewnessthey prefer a higher probability of
larger payoffs
Skewness and Portfolio
Analysis
Value at Risk
Semivariance
Measures downside risk relative to a benchmark
VaR is the standard measure of downside risk
Measures the least expected loss that will be obtained
at a given probability
Dependent on an accurate measure of tail area
probability
Alternative: Tail Conditional Expectation
Measures downside risk by a measure of the expected
return less than the benchmark. This corresponds to
the first lower partial moment of returnsgives rise to
a first-order stochastic dominance criterion for
choosing among portfolios
VaR
The use of VaR and other downside risk
measures is motivated by the inadequacy of
variance as a risk measure
Unfortunately, downside risk measures are
difficult to compute and work with in cases
where the distribution of returns is
asymmetrical
VaR will be an underestimate
Roy Criteria
Investment alternatives leading to 100% investment in the riskless
asset.
Investment alternatives leading to infinite borrowing.