Standard Stochastic Dominance

Thierry Post

European Journal of Operational Research, 2016, vol. 248, issue 3, 1009-1020

Abstract: We propose a new Stochastic Dominance (SD) criterion based on standard risk aversion, which assumes decreasing absolute risk aversion and decreasing absolute prudence. To implement the proposed criterion, we develop linear systems of optimality conditions for a given prospect relative to a discrete or polyhedral choice opportunity set in a general state-space model. An empirical application to historical stock market data shows that small-loser stocks are more appealing to standard risk averters than the existing mean-variance (MV) and higher-order SD criteria suggest, due to their upside potential. Depending on the assumed trading strategy and evaluation horizon, accounting for standardness increases the estimated abnormal returns of these stocks by about 50 to 200 basis points per annum relative to MV and higher-order SD criteria. An analysis of the MV tangency portfolio shows that the opportunity cost of the MV approximation to direct utility maximization can be substantial.

Keywords: Decision theory; Stochastic Dominance; Standard risk aversion; Portfolio theory; Linear Programming (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (7)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ejores:v:248:y:2016:i:3:p:1009-1020

DOI: 10.1016/j.ejor.2015.08.038

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