Semi-Metric Portfolio Optimization: A New Algorithm Reducing Simultaneous Asset Shocks

Nick James (), Max Menzies and Jennifer Chan
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Nick James: School of Mathematics and Statistics, University of Melbourne, Parkville, VIC 3010, Australia
Max Menzies: Beijing Institute of Mathematical Sciences and Applications, Tsinghua University, Beijing 101408, China
Jennifer Chan: School of Mathematics and Statistics, University of Sydney, Camperdown, NSW 2006, Australia

Econometrics, 2023, vol. 11, issue 1, 1-33

Abstract: This paper proposes a new method for financial portfolio optimization based on reducing simultaneous asset shocks across a collection of assets. This may be understood as an alternative approach to risk reduction in a portfolio based on a new mathematical quantity. First, we apply recently introduced semi-metrics between finite sets to determine the distance between time series’ structural breaks. Then, we build on the classical portfolio optimization theory of Markowitz and use this distance between asset structural breaks for our penalty function, rather than portfolio variance. Our experiments are promising: on synthetic data, we show that our proposed method does indeed diversify among time series with highly similar structural breaks and enjoys advantages over existing metrics between sets. On real data, experiments illustrate that our proposed optimization method performs well relative to nine other commonly used options, producing the second-highest returns, the lowest volatility, and second-lowest drawdown. The main implication for this method in portfolio management is reducing simultaneous asset shocks and potentially sharp associated drawdowns during periods of highly similar structural breaks, such as a market crisis. Our method adds to a considerable literature of portfolio optimization techniques in econometrics and could complement these via portfolio averaging.

Keywords: portfolio optimization; time series analysis; change point detection; nonlinear dynamics; market crises (search for similar items in EconPapers)
JEL-codes: B23 C C00 C01 C1 C2 C3 C4 C5 C8 (search for similar items in EconPapers)
Date: 2023
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

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