Building portfolios based on machine learning predictions

Tomasz Kaczmarek and Katarzyna Perez

Economic Research-Ekonomska Istraživanja, 2022, vol. 35, issue 1, 19-37

Abstract: This paper demonstrates that portfolio optimization techniques represented by Markowitz mean-variance and Hierarchical Risk Parity (HRP) optimizers increase the risk-adjusted return of portfolios built with stocks preselected with a machine learning tool. We apply the random forest method to predict the cross-section of expected excess returns and choose n stocks with the highest monthly predictions. We compare three different techniques—mean-variance, HRP, and 1/N— for portfolio weight creation using returns of stocks from the S&P500 and STOXX600 for robustness. The out-of-sample results show that both mean-variance and HRP optimizers outperform the 1/N rule. This conclusion is in the opposition to a common criticism of optimizers’ efficiency and presents a new light on their potential practical usage.

Date: 2022
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DOI: 10.1080/1331677X.2021.1875865

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