Portfolio selection with probabilistic utility |
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Authors: | Robert Marschinski Pietro Rossi Massimo Tavoni Flavio Cocco |
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Institution: | (1) Prometeia S.r.l., Via Marconi 43, 40122 Bologna, Italy;(2) Potsdam Institute for Climate Impact Research, P.O. Box 601203, 14412 Potsdam, Germany;(3) Fondazione Eni Enrico Mattei, C.so Magenta 63, 20123 Milano, Italy |
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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. |
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Keywords: | Portfolio selection Estimation error Parameter uncertainty Probabilistic utility Asset allocation |
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