Focusing on the worst state for robust investing

Woo Chang Kim, Jang Ho Kim, John Michael Mulvey, Frank J. Fabozzi

Research output: Contribution to journalArticle

6 Scopus citations

Abstract

Despite its shortcomings, the Markowitz model remains the norm for asset allocation and portfolio construction. A major issue involves sensitivity of the model's solution to its input parameters. The prevailing approach employed by practitioners to overcome this problem is to use worst-case optimization. Generally, these methods have been adopted without incorporating equity market behavior and we believe that an analysis is necessary. Therefore, in this paper, we present the importance of market information during the worst state for achieving robust performance. We focus on the equity market and find that the optimal portfolio in a market with multiple states is the portfolio with robust returns and observe that focusing on the worst market state provides robust returns. Furthermore, we propose alternative robust approaches that emphasize returns during market downside periods without solving worst-case optimization problems. Through our analyses, we demonstrate the value of focusing on the worst market state and as a result find support for the value of worst-case optimization for achieving portfolio robustness.

Original languageEnglish (US)
Pages (from-to)19-31
Number of pages13
JournalInternational Review of Financial Analysis
Volume39
DOIs
StatePublished - May 1 2015

All Science Journal Classification (ASJC) codes

  • Finance
  • Economics and Econometrics

Keywords

  • Investment analysis
  • Mean-variance model
  • Robust portfolios
  • Worst market state
  • Worst-case optimization

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