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Portfolio selection with probabilistic utility

Robert Marschinski, Pietro Rossi, Massimo Tavoni () and Flavio Cocco

Annals of Operations Research, 2007, vol. 151, issue 1, 223-239

Abstract: Inspired by statistical physics, we present a probabilistic approach to portfolio selection. Instead of seeking the global extremum of some chosen utility function, we reinterpret the latter as a probability distribution of ‘optimal’ portfolios, and select the portfolio that is given by the mean value with respect to that distribution. Compared to the standard maximization of expected utility, this approach has several attractive features. First, it significantly reduces the excessive sensitivity to external parameters that often plague optimization procedures. Second, it mitigates the commonly observed concentration on too few assets; and third, it provides a natural and consistent way to account for the incompleteness of information and the aversion to uncertainty. Supportive empirical evidence is derived by using artificial data to simulate finite-sample behavior and out-of-sample performance. Copyright Springer Science+Business Media, LLC 2007

Keywords: Portfolio selection; Estimation error; Parameter uncertainty; Probabilistic utility; Asset allocation (search for similar items in EconPapers)
Date: 2007
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DOI: 10.1007/s10479-006-0117-5

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