Don’t get dominated by your payday loan
To simulate a realistic decision-making process we apply a backtesting methodology. Sample means and risk measures are estimated for the subperiod January 1987 to September 1998. In those cases where the return series is adjusted for autocorrelation the estimation of the desmoothing parameters is also based on the shortened sample period. Then the portfolios are optimized. With the obtained weights the series of monthly out-ofsample returns for each portfolio is calculated for the period October 1998 to September 2003. Based on this out-of-sample period the risk-return characteristics of the optimized portfolios and the benefits of the optimization approaches are examined.
To determine the set of efficient portfolios, pairwise tests for secondorder stochastic dominance are conducted. When borrowing and lending are allowed and considered in the stochastic dominance algorithm the efficient set contains only one portfolio. It was obtained by minimizing portfolio risk in a shortfall risk framework. This portfolio does not only dominate the performance of the other optimized portfolios but also of every single asset class. Obviously the approaches that take into account skewness and kurtosis of the return distributions yield portfolios with a superior risk-return profile. Three more portfolios that result from using the shortfall risk or Corning–Fisher approach are contained in the efficient set when borrowing and lending constraints are imposed.
Furthermore it should be noted that adjusting for autocorrelation during the process of portfolio construction has a positive effect on the out-of-sample performance of the chosen portfolios.
