A Global-Optimal Portfolio Theory beyond the R-σ Model

Abstract

Deviations from the efficient market hypothesis allow us to benefit from risk premium in financial markets. We propose a three-pronged (R, σ, H) theory to generalize the (R, σ) model and present the formulation of a three-pronged (R, σ, H) model and its Pareto-optimal solution. We define the local-optimal weights (wR, wσ,wH) that construct the triangle of the quasi-optimal investing subspace and further define the centroid or incenter of the triangle as the optimal investing weights that optimize the mean return, risk premium, and volatility risk. By numerically investigating the Chinese stock market, we demonstrate the validity of this formulation method. The proposed theory provides investors of different styles (conservative or aggressive) an efficient way to design portfolios in financial markets to maximize the mean return while minimizing the volatility risk.

Keywords

portfolio / R-σ model / Hurst exponent / risk premium / volatility / Chinese stock market

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2020 Higher Education Press