General linear formulations of stochastic dominance criteria

Thierry Post, Miloš Kopa

Research output: Contribution to journalArticle

43 Citations (Scopus)

Abstract

We develop and implement linear formulations of general Nth order stochastic dominance criteria for discrete probability distributions. Our approach is based on a piece-wise polynomial representation of utility and its derivatives and can be implemented by solving a relatively small system of linear inequalities. This approach allows for comparing a given prospect with a discrete set of alternative prospects as well as for comparison with a polyhedral set of linear combinations of prospects. We also derive a linear dual formulation in terms of lower partial moments and co-lower partial moments. An empirical application to historical stock market data suggests that the passive stock market portfolio is highly inefficient relative to actively managed portfolios for all investment horizons and for nearly all investors. The results also illustrate that the mean-variance rule and second-order stochastic dominance rule may not detect market portfolio inefficiency because of non-trivial violations of non-satiation and prudence.

Original languageEnglish
Pages (from-to)321-332
Number of pages12
JournalEuropean Journal of Operational Research
Volume230
Issue number2
DOIs
Publication statusPublished - Oct 16 2013

Keywords

  • Stochastic dominance Utility theory Non-satiation Risk aversion Prudence Temperance

ASJC Scopus subject areas

  • Computer Science(all)
  • Modelling and Simulation
  • Management Science and Operations Research
  • Information Systems and Management

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