The Effects of Shifts in A Return Distribution On Optimal Portfolios

THE EFFECTS OF SHIFTS IN A
RETURN DISTRIBUTION ON
OPTIMAL PORTFOLIOS
Josef Hadar & Tae Kun Seo

Southern Methodist University, U.S.A.
Presented by
Deepan Kumar Das
Introduction
The paper primarily focuses on:

The necessary conditions on an investors utility function, which are
necessary and sufficient for a dominating shift to bring
about:
No decrease in the investment in the respective asset if

there are only 2 risky assets in the portfolio
and when there are more than 2 risky assets in the portfolio
A summary on "The efects of shifts in a return distribution on optimal portfolios" presented by Deepan Kumar Das at Thursday,
2
Brock University November 2, 2017
Some Clarification
What is a dominating shift?
Defined by Stochastic Dominance which:
allows one to determine the preference of an expected utility maximizer

between some assets with minimal knowledge of the decision makers utility
function.
3
Some Clarification
Types of Stochastic Dominance:
First Order Stochastic Dominance (FSD): Asset has FSD over asset if for any
outcome , gives at least as high a probability of receiving at least as does ,
and for some , gives a higher probability of receiving at least .
Notation: [ ] [ ] for all and for some [ ] > [ ]
In other words, asset first-order stochastically dominates asset every

expected utility maximizer with an increasing utility function prefers asset
over asset , and
The decision maker prefers to regardless of what is, as long as it is weakly
increasing.
4
Some Clarification
Types of Stochastic Dominance:
Second Order Stochastic Dominance (SSD): the decision maker prefers to as

long as he is risk averse and is weakly increasing.
second-order stochastically dominates the decision maker weakly
prefers to under every weakly increasing concave utility function .
5
Some Clarification
What is dominating shift:
The 3rd shift used in this research is Mean Preserving

Contraction (MPC). But before that let us know Mean
Preserving Spread which:
is a change from one probability distribution to another probability
distribution , where is formed by spreading out one or more portions of s
PDF or PMF while leaving the mean (the expected value) unchanged.
6
Some Clarification
What is dominating shift:
The 3rd shift used in this research is Mean Preserving

Contraction (MPC).
is said to be a MPC of if is a mean-preserving spread of .
7
Motivation
In all previous studies the effects of shifts were analyzed on a

portfolio having 2 assets: 1 risky and 1 risk-free.
Arrow (1971), Rothschild and Stiglitz (1971), Fishburn and Porter (1976),
Kira and Ziemba (1980), Cheng, Magill and Shafer (1987), and Landsberger and
Meilijson (1990)
To the best of their knowledge such studies were not done on a

portfolio having assets > 2.
8
Motivation
The analysis for portfolios with two or more assets is rather difficult.
Hart (1975) has shown that in order to derive the desired effects of
changes in the investor's wealth, the utility function must possess
a particular type of separation property.
It turns out that not many classes of utility functions satisfy this
property.
9
Research Questions
How does a risk averse investor adjust the proportions of the

assets in his portfolio when the distribution of one of the assets
undergoes some general types of shift?
10
Contributions in the Research
Extending these earlier works by considering portfolios with more

than one risky asset
Analyzing the effects of three types of shifts: shifts in the sense of
FSD, MPC and SSD
Providing very simple conditions on the utility function, which are
necessary and sufficient for a dominating shift in the distribution of
an asset not causing a decrease in the investment in that asset
Showing that the conditions that result in an increase in an asset
when the portfolio contains only two assets are still necessary when
there are assets
11
Research Models
Portfolios with 2 risky assets
a typical portfolio is a mixture of two assets whose random returns are and .

Thus, the investor's terminal wealth is given by + 1 , with
being the proportion of the investor's funds invested in asset .
The optimal proportion of asset is denoted by . The distribution functions

of and are denoted by and , respectively. All the returns lie in the
interval [0, ].
12
Research Models
The analysis is simplified if we assume that, given the initial distribution of

0 = [(0 0 + 1 0 )] attains
returns, expected utility,
a unique, regular, interior maximum;
i.e. 0 < < 1, and
2
(0 )/02 |0=0 < 0
13
Research Models
The proofs of the theorems are made simplified utilizing several lemmas:
Lemma 1:
For any function which is thrice differentiable, the following functions were
defined:
: , = [ + 1 ]( ), and =
14
Research Models and Results
The following statements are held true:
15
The 3 shifts: FSD, MPC and SSD are considered. In each case the shift is such
that he new distribution dominates the initial one.
FSD Shifts
16
MPC Shifts
One may conjecture that a risk averter will increase the investment in the asset whose
riskiness has diminished. On the face of it, this turns out to be false!
One possible explanation for this result is the presence of substitution and "income"
effects which have opposite signs.
In order to justify such an explanation formally, one should be able to devise some
compensation mechanism such that a compensated shift in the distribution of returns
will not bring about a decrease in the amount invested in asset .
17
MPC Shifts
So, what type of utility functions will the investment in X not decrease following an
MPC shift?
18
SSD Shifts
SSD shifts can be thought of as combinations of an FSD and an MPC shift. This
relationship is formalized in the following lemma.

19
SSD Shifts
Since an SSD shift is a combination of an FSD shift and an MPC shift, it is not
surprising that the set of investors who do not decrease their investment in when
its distribution undergoes an SSD shift consists of those investors who do not
decrease their investment in in response to an FSD shift as well as in response to
an MPC shift. Hence the following result:
20
The Comparative Statics and Optimal Proportion
The problem of how an investor adjusts his portfolio as a result of a shift in the
distribution of one of the assets is very closely related to the problem of choosing the
optimal proportions of the assets included in the portfolio.
21
It was found that, in general, a risk averse investor may not necessarily invest at least
as much in the dominating asset as in the dominated one.
It was, however, established that an investor will invest at least as much in the
dominating asset if and only if his utility function satisfies a certain property. This
property, it turns out, is exactly the same as that which determines the investor's
response to a shift in the distribution of one of the assets.
22

The result is summarized below:
23
Portfolios with n risky assets

When considering portfolios with more than 2 assets, one may want to answer
the following four questions (the answer to each of which is in the affirmative
when = 2):
24
First it is shown that the restrictions placed on in Theorems 1 and 2 are

still necessary when > 2.
25
In reply to question (iii), the following theorem is introduced:
26
Finally it is shown that the answer to Question (iv) is also in the affirmative.
27
Theorems 4 and 6 show that the necessity parts of Theorems 1 and 2 carry
over to portfolios with n assets. It is, therefore, possible to partially extend
Corollary 1 as Corollary 2 stated below:
28
2 special cases
In the last case it is assumed that the investor's utility function exhibits constant
absolute risk aversion; that is, the utility function is exponential. As it turns out,
the effects of shifts in the return distribution of an asset depend on whether or
not the portfolio contains a riskless asset.
29
2 special cases
30
Conclusion
The authors have analyzed the effects of shifts in the distribution of

an asset on the optimal proportions of the assets in a portfolio.
It was shown that, in general, a risk averse investor will not
necessarily increase the proportions of an asset whose distribution
has undergone a dominating shift.
For the case of portfolios with two risky assets, the paper provides
conditions that are necessary and sufficient for a dominating shift
(FSD, MPC, or SSD) to result in an increase (or at least no decrease) in
the proportion of the respective asset.
31
Conclusion
When the portfolio contains n (n > 2) risky assets the analysis is

considerably more difficult.
The conditions provided for the case of 2-asset portfolios were
shown to be necessary also for n-asset portfolios.
It was further shown that the conditions provided for the case of n = 2
are necessary and sufficient even for the case n > 2 if the investor
exhibits constant absolute risk aversion.
In the latter case a shift in the distribution of an asset can produce
two rather different outcomes depending on whether or not the
portfolio contains a safe asset.
32
Thank You
33

The Effects of Shifts in A Return Distribution On Optimal Portfolios

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THE EFFECTS OF SHIFTS IN A

Josef Hadar & Tae Kun Seo

The paper primarily focuses on:

No decrease in the investment in the respective asset if

What is a dominating shift?

Defined by Stochastic Dominance which:

allows one to determine the preference of an expected utility maximizer

Types of Stochastic Dominance:

Notation: [ ] [ ] for all and for some [ ] > [ ]

In other words, asset first-order stochastically dominates asset every

Types of Stochastic Dominance:

Second Order Stochastic Dominance (SSD): the decision maker prefers to as

What is dominating shift:

The 3rd shift used in this research is Mean Preserving

What is dominating shift:

The 3rd shift used in this research is Mean Preserving

is said to be a MPC of if is a mean-preserving spread of .

In all previous studies the effects of shifts were analyzed on a

To the best of their knowledge such studies were not done on a

How does a risk averse investor adjust the proportions of the

Extending these earlier works by considering portfolios with more

Portfolios with 2 risky assets

The optimal proportion of asset is denoted by . The distribution functions

Portfolios with 2 risky assets

The analysis is simplified if we assume that, given the initial distribution of

Portfolios with 2 risky assets

Portfolios with 2 risky assets

The following statements are held true:

Portfolios with 2 risky assets

Portfolios with 2 risky assets

Portfolios with 2 risky assets

Portfolios with 2 risky assets

Portfolios with 2 risky assets

Portfolios with 2 risky assets

The Comparative Statics and Optimal Proportion

Portfolios with 2 risky assets

The Comparative Statics and Optimal Proportion

Portfolios with 2 risky assets

The Comparative Statics and Optimal Proportion

Portfolios with n risky assets

Portfolios with n risky assets

First it is shown that the restrictions placed on in Theorems 1 and 2 are

Portfolios with n risky assets

In reply to question (iii), the following theorem is introduced:

Portfolios with n risky assets

Portfolios with n risky assets

The authors have analyzed the effects of shifts in the distribution of

When the portfolio contains n (n > 2) risky assets the analysis is

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