Working Paper: NBER ID: w9861
Authors: Martin B. Haugh; Leonid Kogan; Jiang Wang
Abstract: The performance of a given portfolio policy can in principle be evaluated by comparing its expected utility with that of the optimal policy. Unfortunately, the optimal policy is usually not computable in which case a direct comparison is impossible. In this paper we solve this problem by using the given portfolio policy to construct an upper bound on the unknown maximum expected utility. This construction is based on a dual formulation of the portfolio optimization problem. When the upper bound is close to the expected utility achieved by the given portfolio policy, the potential utility loss of this policy is guaranteed to be small. Our algorithm can be used to evaluate portfolio policies in models with incomplete markets and position constraints. We illustrate our methodology by analyzing the static and myopic policies in markets with return predictability and constraints on short sales and borrowing.
Keywords: No keywords provided
JEL Codes: G11; C63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| dual formulation of the portfolio optimization problem (C61) | upper bound on the expected utility of a given portfolio policy (D81) |
| upper bound approaches expected utility of candidate policy (D81) | utility cost of selecting that suboptimal policy is small (D81) |
| ignoring the hedging component (G40) | significant effect on expected utility in long-horizon problems and those with nonlinear dynamics (D81) |
| return predictability (C53) | implications on portfolio choices (G11) |