A STOCHASTIC CONVERGENCE MODEL

FOR PORTFOLIO SELECTION

AMY V. PUELZ
apuelz@swbell.net
(Received September 1998; revision received September 1999; accepted November 2000)
Portfolio selection techniques must provide decision makers with a dynamic model framework that incorporates realistic assumptions
regarding nancial markets, risk preferences, and required portfolio characteristics. Unfortunately, multistage stochastic programming (SP)
models for portfolio selection very quickly become intractable as assumptions are relaxed and uncertainty is introduced. In this paper, I
present an alternative model framework for portfolio selection, stochastic convergence (SC), that systematically incorporates uncertainty
under a realistic assumption set. The optimal portfolio is derived through an iterative procedure, where portfolio plans are evaluated under
many possible future scenarios then revised until the model converges to the optimal plan. This approach allows for scenario analysis over
all stochastic components, requires no limitation on the structural form of the objective or constraints, and permits evaluation over any
length planning horizon while maintaining model tractability by aggregating the scenario tree at each stage in the solution process. Through
focused aggregation schemes, the SC approach allows for the implementation of a lower partial variance risk metric, which is preferred in
investment selection. In simulated tests, the SC model, with scenario aggregation, generated portfolios exhibiting performance similar to
those generated using the SP model form with no aggregation. Empirical tests using historical fund returns show that a multiperiod SC
decision strategy outperforms various benchmark strategies over a long-term test horizon under both asset-liability matching and return
maximization frameworks.

resulting in an optimization model whose size is independent of the number of scenarios used to represent uncertainty. The reduced size of the SC model is such that the
solution process can be implemented on virtually any platform, the objective can accommodate any form of discrete
or continuous risk metric, and special form side constraints
unique to the decision-making environment can be incorporated. In addition, through the use of focused aggregation
schemes, preferred lower partial variance based risk metrics can be implemented.
Simulated and empirical tests reveal that SC generates
superior performing portfolios. In simulated tests, SC with
scenario aggregation generated portfolios exhibiting performance similar to those generated using SP with no aggregation. Historical fund returns were used in empirical tests to
examine SC from a strategic perspective and compare it to
individual fund performance and benchmark strategies over
an extended time horizon. Multiperiod SC portfolio selection strategies consistently outperformed other strategies.
The next section provides background on portfolio selection problems and stochastic programming techniques for
solution generation. The framework for the SC is then presented followed by simulated and empirical tests of model
performance.

he selection of a portfolio whose performance is

superior to other portfolio alternatives is a complex
problem for which even a reasonable solution can result
in high potential payoffs. The gap between practice and
theory is small with there being a lucrative market for
new techniques for funds management (Bernstein 1995,
Kahn 1995). Whether the portfolio is designed to fund a
rms pension plan, an insurers loss reserve, or a corporations nancial planning needs, the selection process
should incorporate the complexities inherent in nancial
markets and the decision makers risk preferences and portfolio requirements. In short, there is a need for portfolio
selection models that incorporate problem-specic uncertainties while maintaining model validity and tractability.
Scenario based stochastic programming (SP) models, where
uncertainty is embedded in a utility maximizing framework,
have been shown to be a promising tool for nancial decision making (Koskosidis and Duarte 1997, Golub et al.
1995, Holmer and Zenios 1995, Cario et al. 1994). This
paper sets forth such a stochastic optimization technique,
stochastic convergence (SC).
SC is based on stochastic programming (SP) models for
portfolio selection, and like SP, provides a robust modeling
procedure generating utility maximizing portfolios while
controlling performance variability. Unlike SP, SC eliminates the need for all simplifying assumptions necessary
for decomposition and solution generation by employing
an iterative selection procedure of simulation evaluation of
revised portfolios. The procedure is implemented through
the use of scenario aggregation at each step in the process

1. BACKGROUND
Research into the development of models for portfolio
selection under uncertainty dates back to the fties with
Markowitzs (1959) pioneering work on mean-variance efcient (MV) portfolios. Unfortunately, MV models have

Subject classications: Finance, portfolio: stochastic optimization selection model. Programming, stochastic: convergence model for portfolio selection. Finance, investment:
stochastic optimization for portfolio selection.
Area of review: Financial Services.
Operations Research 2002 INFORMS
Vol. 50, No. 3, MayJune 2002, pp. 462476

462

0030-364X/02/5003-0462 $05.00
1526-5463 electronic ISSN

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practical limitations, such as the requirement that stochastic
parameters are symmetrically distributed or the investors
utility function is quadratic. MV models, not easily
extended to a multiperiod planning horizon, provide a range
of efcient solutions rather than a single optimal solution, and solutions have been shown to be extremely sensitive to very small changes in model forecasts (Mulvey
and Vladimirou 1989, Jai and Dyer 1996, Koskosidis
and Duarte 1997). Stochastic programming (SP), where
expected utility is maximized across a range of possible
future outcomes or scenarios provides a better framework for the class of portfolio selection problems. Cario
et al. (1994) show signicant savings can be realized by
replacing a MV portfolio selection approach with scenariobased stochastic programming. Holmer and Zenios (1995)
discuss the importance of dynamic scenario-based decision models in integrated product management for nancial
intermediaries.
SP requires the specication of random parameter joint
distributions through discrete data realizations of possible
future states or scenarios. In the objective function, the
probability-weighted utility of performance across all scenarios is maximized. The most signicant limitation in SP
implementation is that as the number of scenarios increases
to adequately represent the joint distribution of random
parameters the model becomes prohibitively large.
Research in SP for portfolio selection is focused
on models that incorporate realistic assumptions while
remaining computationally tractable. Various forms of SP
have been applied to a range of portfolio selection problems. Bradley and Crane (1972) discuss the need for
dynamic, multistage models for bond selection and provide a decomposition procedure for solution generation.
Kallberg et al. (1982) develop a simple recourse linear
programming model allowing for asymmetric preferences
or differing penalty costs. In testing their model, they illustrate that by incorporating randomness in cash requirements they are able to extend the scope of portfolio modeling without a signicant impact on model tractability.
Kusy and Ziemba (1986) apply stochastic LP to bank
asset and liability management. Like the Kallberg, White,
and Ziemba model, their model allows for randomness in
external deposits and withdraws only while asset returns
are assumed deterministic.
More recently, Hiller and Eckstein (1993), Mulvey and
Vladimirou (1989, 1992), Zenios (1991) and Golub et al.
(1995) have developed SP network models that allow
for a broader range of parameter uncertainty. Hiller and
Ecksteins (1993) stochastic dedication model for xedincome portfolios employs an arbitrage-free pricing mechanism in the scenario generation process. Notable in their
model is the risk measure, which reects the probability
and severity of insolvency in a manner similar to the
lower partial variance metric. This type of metric has been
shown by Bawa (1975) and Fishburn (1977) to provide a
better measure of risk when abnormally low returns are
of concern. Before Hiller and Ecksteins (1993) model,

463

the implementation of such a risk metric was considered

computationally intractable. However, to maintain a structure suitable for model decomposition and solution generation, their model evaluates the decision over a single-period
time horizon. Since rebalancing is not allowed in a singleperiod framework, the associated transaction costs are not
considered in their portfolio selection process. In the SC
framework the variability of low returns can be measured
independently of overall variability through focused aggregation schemes making it possible to implement a lower
partial variance metric allowing for control of downside
risk.
Mulvey and Vladimirou (1989, 1992) develop a generalized network approach for multiperiod nancial management, allowing for uncertainty in virtually all stochastic
parameters. To maintain a structure necessary for decomposition, all multiperiod investments are treated as zerocoupon bonds by forcing the reinvestment of cash spinoffs.
In other words, the model assumes cash ows from assets
cannot be used to meet cash requirements until assets
mature or are liquidated. The assumption of dividend reinvestment can be a limitation in asset-liability management,
where in many cases assets are purchased because cash
spin-offs can be used to meet future cash requirements
without liquidation. Zenios (1991) extends the Mulvey and
Vladimirou model to include mortgage-backed securities
and other xed-income securities using an arbitrage term
structure model for scenario generation of bond prices.
Golub et al. (1995) develop a two-stage SP model for xedincome securities and compare the performance of their
model to other strategies for money management using
mortgage-backed securities. They show through a simulated
test procedure that a SP model strategy results in superior
performance and is worth the added complexity in terms of
scenario and solution generation procedures.
Robust optimization (RO) models, which are a class of
SP models, incorporate a nonlinear objective function to
generate portfolios that control for performance variability.
RO models generate solutions that minimize performance
sensitivity to data realizations. In a portfolio planning context, the variability of the portfolio return is controlled in a
risk-averse framework. Mulvey et al. (1995) provide a general RO framework. Bai et al. (1997) compare and contrast
RO to other techniques for optimization under uncertainty
and provide a specic framework for nancial planning
problems. Vladimirou and Zenios (1997) develop three SP
models with restricted recourse for RO and show effective
solution generation experience for small to medium scale
problems.
It is evident from the literature that superior performance
can be realized by using SP for nancial decision making.
However, it is also evident throughout the literature that
SP model size is a signicant drawback to actual implementation. Realistically sized, multiperiod SP models for
portfolio selection must maintain a structure that is suitable for decomposition. This may require (1) viewing the
problem in a myopic framework, (2) limiting the number

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of stochastic components evaluated, (3) allowing cash spinoffs only at maturity or liquidation, and/or (4) limiting
special form side constraints unique to the problem at
hand. Even if a structure suitable for decomposition is
maintained, the task of solving the system of subproblems
becomes signicant when the number of stochastic components, assets in the selection set and time periods in the
planning horizon, increases. In short, as Dahl et al. (1993)
point out, the combinatorial explosion of scenarios in
SP nancial planning models makes the need to capture uncertainty in a systematic way of great importance
(p. 34). It is this need to incorporate uncertainty while
maintaining model validity and tractability that is addressed
in this research.

Figure 1.

Structure of the SC model.

SIMULATION

SCENARIO TREE
(See Figure 2a)

INITIAL
PORTFOLIO PLAN

Determine Wealth
Time Period 1

Wealth
Category 1

Wealth
Category K

Aggregation
Step

STOP
Yes

2. THE SC FRAMEWORK
SC is an iterative approach for addressing utility maximizing portfolio selection problems that allows for scenario
analysis over all stochastic components, while maintaining
model tractability through scenario aggregation at each
stage. Aggregating scenarios into categories eliminates the
need for decomposition and associated model simplications as the size of the optimization model is reduced to a
linear function of the deterministic model and the number
of aggregation categories. There are no limits on special form side constraints as in network models requiring
decomposition. In addition, the risk metric can take any
functional form, discrete or continuous, depending on the
decision-makers risk preferences.
In SC, the optimal portfolio is derived through an iterative procedure where portfolio plans are evaluated under
many possible scenarios and revised. The cycle of scenario
evaluation of revised portfolios continues until the model
converges to the optimal portfolio plan. One can also think
of SC as a portfolio improvement model where at each iteration revisions are made to the current portfolio to improve
its performance. The SC process is illustrated in Figure 1.
In the rst stage of the selection process, an initial portfolio plan consisting of asset-liability allocations for each
period in the planning horizon is derived. The plan could be
derived from a deterministic model using expected parameters or it could be based on a benchmark portfolio.1
As in all stochastic models a set of scenarios is generated that represents possible future data realizations of
all random model parameters over the desired planning
horizon. In a nancial planning context, random parameters might include interest rates, asset returns, and liability
costs. The number and type of random parameters will vary
from model to model as will the technique used to generate
random data realizations.2 The scenario specic random
parameters in a portfolio planning context are presented in
Table 1.
The process of creating scenarios starts with the generation of stochastic parameter data realizations at the end of
the rst period. The clock is then rolled forward one period
and second period data realizations are generated given the

No

New
Portfolio
Plan?

AGGREGATED
SCENARIO TREE
(See Figure 2b)

OPTIMIZATION

starting state described by each rst period ending state.

This process continues until data realizations are generated
for each period in the planning horizon. The general form
of the scenario tree representing these data realizations is
represented in Figure 2a. The tree nodes represent points
in time when new information about random parameters
(such as asset, rate, and cash requirements) is available to
use in decision making. Each distinct branch in the tree
represents one of the J scenarios containing a unique set
of data realizations.
The initial portfolio plan is evaluated under each of
the J distinct scenarios and wealth determined at the end
of the rst period. Scenarios are grouped together based
on rst-period wealth into K categories and random data
realizations are averaged across all scenarios in a group
creating an aggregated scenario. The form of the aggregated scenario tree is found in Figure 2b. Scenarios are
grouped by wealth at the end of the rst period because of
the dynamic nature of the multiperiod portfolio selection
Table 1.
Variable
rth 
pih t 

ai t 
bt 

Simulation model variables.

Description
One-period interest rate time t under scenario 
(h = b for borrowing rate and l for lending rate)
Market price (h = m), sales price (h = s) or purchase
price (h = b) for one unit of asset i time t under
scenario  (sales and purchase prices include all
transaction costs)
Cash ow for one unit of asset i at time t under
scenario .
External cash ow time t under scenario 

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Figure 2.

465

Scenario tree aggregation.

problem.3 After the rst period, new scenario-specic information is available and portfolio plans become scenario
dependent. It is only through the rst-period that nonanticipatory conditions require that portfolio decisions be identical across scenarios.
Determining the ranges of the wealth aggregation categories will depend on the decision-makers utility function.
If the utility function is a continuous concave function,
aggregation could be accomplished by assigning an equal
number of scenarios to each of the K aggregation categories. This is the approach used in the simulated tests. In

the empirical tests, a different approach is used. In these

tests, scenarios with rst-period wealth above the median
(high wealth outcomes) are grouped together and scenarios
with wealth below the median (low wealth outcomes) are
separated into the remaining K 1 categories. This aggregation approach allows for risk assessment focused on the
worst or below average outcomes resulting in a preferred
lower partial variance related risk metric.4 If risk is to be
measured by a discrete form metric such as value at risk,
VaR, grouping of scenarios would be dependent on the
decision-makers denition and acceptable probability of

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worst case performance. It is also possible for risk assessment to vary in functional form from category to category.
The aggregated scenario tree in Figure 2b is used to
create the optimization model where a revised portfolio will
be derived. Each time a new revised portfolio is derived
in the optimization process the aggregated scenario tree is
recreated for input to the model. The general form optimization model is:
Max Z =

xik t yth k

k=1

xik t =

St

K

t1


=0

k U wk 
xibk xisk

(1a)
k = 1 to K and
t = 1 to T 

M

(1b)

aki t xik t pibtk xibtk + pistk xistk  + ytb k ytl k

i=1

b k b k
l k
l k
1 + rt1
yt1 + 1 + rt1
yt1
= btk

k = 1 to K and t = 0 to T 1,
M


i=1

(1c)

k
pimTk + aki T xik T 1 + rTb1
yTb k
k
+ 1 + rTl1
yTl k  wk = bTk

xik 1

xih 1 

xil tk 

k = 1 to K

xibtk  ytl k  ytb k

(1d)

0

k = 1 to K and h = 1 to K, k = h

(1e)

with the variables dened in Table 2.

The distribution of the random parameters in the model
given in Table 1, rth  pih t  ai t , and bt  are represented in their aggregate form as rth k , pihkt , aki t , and
btk . The objective function (1a) maximizes the sum of the
probability-weighted utilities of ending wealth, wk . Cumulative holdings of each asset in each time period are dened
in (1b). The constraints in (1c) dene cash ows for each
time period in the planning horizon t, for each category k.
Table 2.
Variable
M
T
K
xihtk
xik t
rth k
pihtk
aki t
btk
yth k
k
wk

Optimization model variables.

Description
Number of assets
Number of time periods
Number of wealth categories in aggregation
Units of asset i bought (h = b) or sold (h = s)
time t in category k
Cumulative holding of asset i time t in category

b k
s k
k =  t1
=0 xi  xi  
h
E rt   category k
E pih t   category k
E ai t   category k
E bt   category k
One-period lending (h = 1) or borrowing (h = b)
time t in category k
Proportion of scenarios in category k
Ending wealth in category k

The constraints in (1d) dene ending wealth for each of the

K categories. Nonanticipatory requirements that rst-period
decisions be identical across all wealth scenario categories
are modeled in (1e). Any other situation-specic side constraints, such as maximum or minimum allocations, can be
added to the general form model.
The optimization model uses new aggregated asset, rate,
and cash requirement information from the initial portfolio to select a revised portfolio with higher expected
utility. In a general risk-averse framework, the revised portfolio, when compared to the initial portfolio used to aggregate, will have higher (lower) allocations to assets that
have relatively high (low) overall returns during periods
when fund performance is below (above) average. Once a
new revised portfolio is derived, the aggregated scenario
tree must be recreated, based on rst-period wealth of the
revised portfolio across scenarios. New expected parameters for aggregated scenarios are derived, the optimization
model re-executed, and the portfolio revised again. The SC
model converges to the optimal plan by shifting the portfolio at each revision to better balance cash ows across
each aggregation category and increase utility. This cycle of
scenario tree aggregation and portfolio revision continues
until the optimal portfolio plan emerges. The model converges to the optimal solution when the portfolio plan does
not change from the previous simulation.
To understand the convergence process, consider a oneperiod planning horizon and two assets, A and B, with
negatively correlated returns. Assume that the initial portfolio is allocated 100% to asset A. Ending wealth will
be perfectly correlated with asset As returns and negatively correlated with asset Bs returns. Thus, for example,
aggregation categories representing relatively low wealth
outcomes will be those where asset B has relatively high
returns. In a risk-averse framework, the revised portfolio
will shift a portion of the portfolio holdings to asset B,
increasing overall utility. When scenarios are reaggregated
based on the revised portfolio, asset B will be less attractive, since ending wealth will not be as negatively correlated with asset Bs returns as in the initial portfolio. When
the portfolio is revised a second time, a portion of asset Bs
holdings will be shifted to asset A. This process of shifting
a portion of holdings between A and B will continue until
steady state is reached and the allocations to A and B do
not change in the revision step.
It is possible that the SC model might converge at a
local optimum that differs from the global optimum. In
Appendix A, the conditions necessary for model convergence to a global optimum are set forth. The most restrictive of these conditions are that (1) the impact that a change
in an assets allocation has on expected utility is uniform
across all aggregation categories (A.4), and (2) an assets
diminishing marginal impact on expected utility, given an
increase in that assets holding is not entirely accounted for
by the joint impact associated with changes in allocations
of the other assets in the selection set (A.6).

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467

The rst required condition is violated when an assets

return behavior varies across aggregation categories. For
example, consider a callable bond with returns and cash
ows that are a discontinuous function of interest rates, and
wealth which is correlated with interest rates. Increasing
the amount held of the callable bond may increase overall
expected utility but the change in expected utility will
vary across aggregation categories based on rst-period
wealth. In this case, the SC model might converge at a
local optimum which is inferior to the global optimum. By
altering the manner in which scenarios are aggregated, this
problem can be solved and the SC technique used given
a selection set containing derivative securities with discontinuous return functions.5
The second required condition for global optimum convergence can be attributed to scenario aggregation. If the
returns on an asset and the set of alternative assets are
highly correlated in either direction, aggregation might well
average out pricing or cash ow characteristics that without
aggregation would have led to the selection of a new superior solution. This problem will be reduced as K (the
number of aggregation categories) increases. Another solution to this problem would be to run the model several
times, placing restrictive constraints on different sets of
highly correlated assets to more fully search the feasible
solution space. Sensitivity analysis could also be used to
revise the aggregation scheme. For example, if the objective function coefcients of decision variables in a particular category have a relatively small optimality range the
category could be divided into two or more categories for
further analysis. The model could also be used in its current form as a portfolio improvement model to evaluate and
improve upon candidate portfolio plans. A Tabu-type search
technique (Glover 1989, 1990) could also be employed to
insure the attainment of the global optimum.
Another consideration in SC is the potential for portfolio
plans to reappear and looping to ensue. This problem is
remedied by implementing a modied branch and bound
algorithm. The algorithm is summarized in Appendix B.
Finally, if rst-period return used for aggregation is not correlated with ending wealth, multiperiod SC will not converge. However, given the nature of the portfolio selection
problem this is not the case (see Endnote 3).

function quadratic in form. Other forms of utility could

be implemented, such as those belonging to the isoelastic
family. Quadratic utility was selected for the model tests
because efcient solution algorithms are available and with
focused aggregation in SC (not possible in SP) the limitations of quadratic utility in portfolio selection can actually
be reduced.6 The initial portfolio plan input into SC for
the tests was derived from the deterministic model where
expected values based on historical returns for all parameters were used.

3. MODEL VALIDATION AND

COMPARATIVE ANALYSIS

Table 3.

Simulated and empirical tests were conducted to examine

the performance of different SC model structures and to
compare them to other strategies for portfolio structuring.
The test results to follow illustrate the impact on model
derived portfolio performance of (1) the level of aggregation in the model, (2) the decision makers level of riskaversion, (3) the length of the planning horizon, and (4)
the nature of external liabilities. In both simulated and
empirical tests, one unit of wealth was allocated to various
investment alternatives with the decision-makers utility

3.1. Simulated Tests

The rst set of tests conducted using simulated asset
returns, illustrates the impact aggregation has on SC performance. Single-period SC models with varying levels of
scenario aggregation were compared to SP models with
no aggregation. The rst step in the simulated tests was
the generation of 250 scenarios, each representing the cash
ows of three assets and one liability which are described
in Table 3.
Using these scenarios, SC models with different numbers of aggregation categories (K = 1, 3 and 6) and an
SP model with no aggregation (K = 250) were executed.
Mean-variance efcient (MV) portfolios were also generated for three target returns of 3.0%, 3.5%, and 4.0%. The
performance of SC- and SP-generated portfolios were compared to illustrate the impact of the number of aggregation
categories on performance. The robustness of SC, SP, and
MV model performance was also compared using a hold
out sample of 250 scenarios not used in model creation.
In Figure 3, the expected minimum and maximum
portfolio returns across all scenarios used in model creation (in-sample scenarios) were averaged over 30 simulation trials.7 Clearly, SC models with complete aggregation (K = 1), where performance variability cannot be
controlled, are inferior to those models which incorporate scenario specic performance. Also evident is that for
lower levels of risk-aversion, fewer categories are necessary in SC to mimic the spread between best and worst
case performance realized using SP. The same relationships
are found in comparing expected minimum and maximum
return performances across a hold out sample of 250 scenarios not used in model creation (out-sample scenarios).
Description of asset/liability cashows for
simulated tests.
Correlation Matrix

Asset 1
Asset 2
Asset 3
Liability

Asset 1

Asset 2

Asset 3

Liability

1 00
0 09
0 93
0 38

0 09
1 00
0 08
0 92

0 93
0 08
1 00
0 32

0 38
0 92
0 32
1 00

Mean
Standard deviation

Asset 1

Asset 2

Asset 3

Liability

1.0291
0.0284

1.0325
0.0529

1.0301
0.0031

0.0314
0.0072

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Figure 3.

Simulation test results averaged over 30 trials

using single-period SC models with 1, 3, and
6 aggregation categories (K = 1, 3, and 6),
and SP models with no aggregation. Mean,
maximum, and minimum ending portfolio
values across 250 scenarios used to create the
model (in-sample scenarios).

25%
20%
15%
10%

Return

5%
0%
-5 %
-10%
-15%
-20%

Ra=10

SP

SC, K=6

SC, K=3

SC, K=1

SP

SC, K=6

SC, K=3

SC, K=1

-25%

Ra=25

Figure 4 compares SC, SP, and MV portfolios in a

risk-return framework plotting average return relative to
standard deviation of returns across the 250 out-sample
scenarios. As seen in Figure 3, the lower the level of riskaversion the more closely SC performance matches SP performance. In general, the greater the number of aggregation
categories in SC, the greater the level of risk control. It is
interesting to note, however, that none of the SC portfolios
are dominated by the comparable SP portfolio. By contrast,
MV portfolios are dominated by both SC and SP portfolios
where asset-liability matching is imbedded in the framework. The exception is the MV portfolio with a high target
return of 4.0% which dominates the deterministic form SC
portfolio with a single aggregation category.
3.2. Empirical Tests
The empirical tests used historical returns from an asset
selection set of 8 funds listed in Table 4. These funds were
selected to represent a broad range of investment alternatives. In addition, all funds paid dividends on a monthly,
quarterly, semiannual, or annual basis. Quarterly price and
dividend data were collected from Bloombergs Financial
Markets service for the period from March 1987 to March
1998 with the test period being the most recent 28 quarters
starting March 1991.
For each quarter in the test period the previous 16
quarters of historical returns were used to estimate future

prices and dividends for the planning horizons tested; fourquarters and one-quarter. The technique used to estimate
returns was the principal component analysis technique
used in Mulvey and Vladimirou (1989).8 Dividends were
estimated based on historical percentage payouts and seasonal patterns. Transaction costs for all models were based
on published load gures with the minimum transaction
costs (for no-load funds) set at 1% . At no point was future
information used for price or dividend estimation.
In validating and testing SC performance, the rolling
horizon approach used in Mulvey and Vladimirou (1992)
was implemented. In the rst quarter of the test period,
March 1991, the model is run assuming the investor has one
unit of wealth to allocate. The model form reects the planning horizon being tested, either one or four quarters. The
resulting rst quarter portfolio decisions are implemented,
the time horizon rolled ahead one quarter and new information incorporated. At this point, the model is re-executed
with the starting portfolio equal to that which would have
been implemented from the previous quarter regardless of
whether a planning horizon of one or four quarters is being
tested. This process of quarterly rebalancing of the portfolio continues throughout the test period. In this manner,
the test replicates the strategy of an investor who on a quarterly basis assimilates new information and rebalances the
portfolio, based on the model-derived optimal plan regardless of the length of the planning horizon.
The actual performances of SC strategies were compared
to the performances of individual funds, several benchmark strategies suggested in Mulvey and Vladimirou (1989,
1992) as representative portfolio strategies and a range of
MV strategies. The allocations associated with different
benchmark strategies are presented in Table 5. The MV
strategy involved deriving mean-variance efcient portfolios using the same historical information used in SC.
The MV portfolios were rebalanced annually, allowing for
a portfolio that reected current return information while
lowering transaction costs relative to quarterly rebalancing.
During periods when rebalancing did not occur, excess
cash was allocated to funds based on the MV percentages
derived at the last rebalancing. Likewise, cash decits were
paid by liquidating funds based on these same percentages.
Figure 5 illustrates the different forms of SC scenario
aggregation used in each test. Wealth categories were
equally distributed below the 50th percentile of expected
wealth at the end of the rst period. Only scenarios where
performance was below average were categorized based
on wealth while scenarios where performance was above
average were aggregated into one category. This type of
focused categorization, where only poorly performing scenarios are aggregated into separate categories, allows for a
risk measure similar to the preferred lower partial variance.
The utility of ending wealth, modeled in the objective
through a quadratic utility function, was dened as
K


k=1

U wk  =

K


k=1

wk !wk2 

(2)

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Figure 4.

469

Simulation test results averaged over 30 trials using single-period SC models with 1, 3, and 6 aggregation
categories (K = 1, 3, and 6), SP models with no aggregation and MV models. Mean return relative to standard
deviation of return over 250 scenarios not used in model creation (out-sample scenarios).

0.0%
-0.1%
r=4.0%

Mean Return

-0.2%

K=1
(Ra=10 & 25)

-0.3%
K=3

-0.4%
r=3.5%

-0.5%

K=6

K=3
K=6

-0.6%
r=3.0%

-0.7%
0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

Standard Deviation of Returns

SC, Ra=10

SC, Ra=25

where wk is ending wealth in category k as dened in

(1d).9 The decision-makers absolute risk-aversion (Ra) was
assumed to be constant and ! decreasing relative to wealth
at the beginning of the quarter, wo , over the 28-quarter test
period. Ra is dened as
Ra =

2!
1 2!wo 

Table 4.

(3)

Fund selection set.

Fund Name
FPA Capital (Mid-cap)
Fidelity Real Estate Investment Portfolio
Principal Preservation Portfolio
S&P 100 Plus Fund
Templeton Growth Fund (global stock)
T Rowe Price International Bond Fund
Vanguard Fixed-Income Long-Term
US Treasury Portfolio
Vangard Fixed-Income Long-Term
Corporate Portfolio
Vanguard Fixed-Income GNMA

Transaction Cost
6.5%
1%
4.5%
5.75%
1%
1%
1%
1%

Note. Transaction costs are based on reported load gures plus

1% processing costs. All fund information was gathered from the
Bloomberg Financial Markets service.

SP, Ra=10

SP, Ra=25

MV

The portfolios were generated for several risk-aversion

levels ranging from Ra = 0 (risk neutral) to Ra = 5.10
Short sales and short-term borrowing were not allowed.
The portfolio was entirely invested in the eight fund alternatives or in the short-term risk-free asset.11 These investment restrictions, which are not requirements in the model
framework, were adopted for testing purposes as they allow
for comparative analysis based on known fund performance.
The rst set of tests were conducted to compare performance in an asset-liability management context. In these
Table 5.

Benchmark strategies.

Portfolio

S&P

LT Govt

LT Corp

Cash

BP1
BP2
BP3
BP4
BP5
BP6
BP7
BP8

20%
45%
55%
60%
65%
75%
90%

40%
30%
20%
15%
40%
10%
15%
5%

40%
30%
25%
20%

20%
20%
10%
10%

15%

10%
10%

5%

Note. Benchmark strategies are the same as those suggested in

Mulvey and Vladimirou (1989, 1992).

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Figure 5.

Scenario aggregation scheme used in empirical tests.

K=1

K=2

Wealth

Wealth

K=4

K=6
U

Wealth

Wealth

tests, the quarterly external liability to be funded was set

equal to the return on a high-yield bond fund offered by
Seligman. This fund was selected to represent external
liabilities because of its excess return kurtosis resulting
in a at tailed return distribution. Dufe and Pan (1997)
show that the return distribution characteristics of equities, exchange rates, commodities, and interest rates are
at tailed, meaning that unusual returns at both ends of
the distribution are more likely than would be predicted
by a comparable normal distribution of returns. This is
illustrated in Figure 6, where the distribution of quarterly
returns on the external liability with kurtosis equal to 0.26
is compared to that under return distribution normality.

Figure 6.

Flat-tailed distribution of actual liability cost

percentage versus comparable distribution
form if normal.

0.25
0.20
0.15
0.10
0.05
0.00
-5%

-2%

+1%

+4%

+7%

+10%

+13%

Return
Actual Probability

Probability if Normal

Mean portfolio return relative to the standard deviation

of portfolio returns allows comparison of different portfolio selection strategies over the 28-quarter test period.
Figure 7 presents the performance of SC strategies, based
on a multiperiod (4 quarter) planning horizon, and different scenario aggregation plans (K = 1 through K = 6)
to the performance of individual funds. When scenarios
were completely aggregated (K = 1), risk-averse behavior
cannot be modeled and the resulting SC strategy performances were almost identical to that of highest risk-return
fund, mid-cap. As would be expected, the higher level of
absolute risk-aversion the lower the standard deviation of
returns over the test period. Also revealed in these comparisons is that the number of aggregation categories (K) is
negatively correlated with the standard deviation of returns
over the test period. This is because as more categories
are added below the 50th percentile of returns, abnormally
low returns become more of a factor in deriving expected
utility. In terms of overall variability as measured by return
standard deviation, none of the SC strategies are dominated
by individual fund performance, and with the exception of
the mid-cap fund, the mean quarterly returns of individual
funds are less then zero, while those for SC strategies are
positive.
In Figure 8, additional results are presented given
funding for the same external liability tied to the return
on a high-yield bond fund. Comparisons are made between
individual fund performance, benchmark strategies, MV
strategies, and myopic and multiperiod SC strategies.12 All
the multiperiod SC strategies resulted in higher returns
than other candidate strategies with the exception of the
mid-cap fund. This can be explained by the fact that
SC incorporates future expected cash spin-off and liability
information along with transaction costs associated with the
future liquidation and rebalancing of assets necessary to
fund liabilities. In addition, the aggregation scheme allowed
for fund selection based on risk measured by low-end return
variability with no risk penalty attached to extremely high
returns. Myopic SC strategies did not perform as well as
multiperiod strategies because of their inability to incorporate transaction costs associated with future portfolio
liquidation and rebalancing decisions, which is particularly
critical when external liabilities are to be funded.
In this set of comparisons, where a risky external liability
is funded, there exists a potential for signicant losses. To
compare performance in a preferred context that accounts
for poor performance (or loss) risk rather than overall variability, the value at risk (VaR) metric is employed. VaR is a
popularly embraced technique for measuring downside risk
in a portfolio, and in the context of losses is dened as the
pth percentile of portfolio quarterly loss. For high p values
(e.g. 99, 95, or 90) it can be thought of as identifying the
worst case outcome of portfolio performance. Figure 9
presents a comparison of the same strategies as in Figure 8,
but with mean returns compared relative to a VaR metric
rather than return standard deviation. In this case VaR is
dened as the 90th percentile of portfolio losses over the

Puelz
Figure 7.

471

Standard deviation relative to mean portfolio quarterly return comparison across number of aggregation categories (K) for multi-period SC strategies, absolute risk-aversion (Ra) equal to 2 and 4.
3%
k=2
k=4
k=6

Mean Portfolio Quarterly Return

2%
k=2

k=4
k=6

1%

mid cap
k=1 (Ra=2 and 4)

0%

real estate
glob stock
S&P

-1%
-2%

LT corp

glob bond

LT govt

-3%
GNMA

-4%
3%

4%

5%

6%

7%

8%

Standard Deviation of Portfolio Quarterly Return

individual funds

28-quarter test period. Viewed in this framework, multiperiod SC strategies and most myopic SC strategies exhibit
superior performance to benchmark and MV strategies. All
individual funds with the exception of the mid-cap fund are
dominated by most SC strategies. Relative to the high riskreturn mid-cap fund, several SC strategies provide several
similar returns with lower VaR.
In the second set of tests external liabilities are eliminated and performance of various strategies examined in

Ra = 4

a pure return maximizing framework rather than in an

asset-liability matching framework as in the last set of tests.
All other model parameters were identical to those used
in the rst set of empirical tests. The results of this set of
tests are found in Figure 10, where mean return is compared relative to standard deviation of returns. In this set of
pure return maximizing models, the multiperiod SC strategies outperformed individual funds, benchmarks, and MV
strategies. The relative improvement is not, however, as

Standard deviation relative to mean portfolio quarterly return comparison across absolute risk-aversion (Ra)
for SC strategies (K = 6), individual funds, benchmark strategies, and mean-variance efcient (MV) strategies.
3.0%
Ra=1
Ra=2 Ra=0
Ra=0

2.0%
Mean Portfolio Quarterly Return

Figure 8.

Ra = 2

Ra=3

mid cap

Ra=4
Ra=5

1.0%

Ra=1

0.0%

real est ate

Ra=3
glob st ock
S&P

Ra=4
Ra=5

-1.0%

bp8

bp7
bp6 bp5

Ra=2

bp4
bp3

-2.0%

LT corp

glob bond
LT govt

bp2
bp1

-3.0%
GNMA

-4.0%
2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

Standard Deviation of Portfolio Quarterly Return

individual funds

benchmarks

MV

SC, multi-period

SC, myopic

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/ Puelz

Figure 9.

VaR relative to mean portfolio quarterly return comparison across absolute risk-aversion (Ra) for SC strategies
(K = 6), individual funds, benchmark strategies, and mean-variance efcient (MV) strategies.
3.0%

Mean Portfolio Quarterly Return

Ra=0 mid cap

Ra=1

Ra=2
Ra=0

2.0%
Ra=3
Ra=4

1.0%

Ra=5
Ra=1

0.0%

real est ate

Ra=3

Ra=4

S&P

bp8

-1.0%
bp5
bp6
bp4

glob st ock

Ra=5

Ra=2

bp7
bp3

-2.0%

LT corp

LT govt

glob bond

bp2
bp1

-3.0%
GNMA

-4.0%
4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

7.5%

8.0%

VaR - 90th Percentile of Portfolio Quarterly Loss

individual funds

benchmarks

MV

signicant as that seen in the previous tests where liabilities

were funded. This is because the SC models incorporation
of cash spin-offs does not have the same impact on performance when external liabilities are not being funded. As in
the last set of tests, myopic SC strategies did not perform as
well compared to benchmark strategies or individual funds.
Again, this can be attributed to the fact that myopic models

SC, myopic

fail to account for transaction costs of future rebalancing

and investment of cash spin-offs.
3.3. Computational Issues
The SC model was implemented in MATLAB on a UNIX
5/300 Alpha processor with 512 MB RAM. The Numeric
Algorithms Group (NAG) quadratic solver was used.

Standard deviation relative to mean portfolio quarterly return comparison across absolute risk-aversion (Ra)
with no external liabilities for SC strategies (K = 6), individual funds, benchmark strategies, and meanvariance efcient (MV) strategies.
6.0%
Ra=0

mid cap

Ra=1

5.5%
Mean Portfolio Quarterly Return

Figure 10.

SC, multi-period

Ra=0

5.0%
4.5%

Ra=2
S&P

Ra=3

4.0%

Ra=4
Ra=5
bp7

3.5%

bp5

bp6

Ra=5
bp4
bp3

LT corp

bp2

3.0%

Ra=1

Ra=3

LT govt
glob bond

bp1

2.0% GNMA
2.0%

real est ate

Ra=4

3.0%
2.5%

Ra=2

bp8
glob st ock

4.0%

5.0%

6.0%

7.0%

8.0%

Standard Deviation of Portfolio Quarterly Return

individual funds

benchmarks

MV

SC, multi-period

SC, myopic

Puelz
Figure 11.

A comparison of average CPU time for

multiperiod SC model portfolio generation.
CPU time is divided into the average total
time to run NAG quadratic optimization
model and test for convergence and the
average total time to generate and aggregate
scenarios.

K=1
K=2
Ra=2
K=4
K=6
Ra=0
Ra=1
K=6

Ra=2
Ra=3
Ra=5

0.00

100.00
200.00
CPU time in Seconds

Optimization and convergence testing

300.00

800.00
400.00

Scenario generation and aggregation

The average CPU times required to derive optimal portfolios using the multiperiod model over the empirical test
period are presented in Figure 11 for various model characteristics. In the empirical tests, the number of scenarios
generated in the model ranged from 3,000 to 6,000. In addition, when the portfolio asset allocations changed by less
than one-percent from the previous cycle, optimal portfolio
convergence was assumed.
The average CPU total time is divided into two categories, (1) the time required to run the optimization models
using NAGs quadratic solver and test for portfolio convergence, and (2) the time required to generate and aggregate
scenarios using the Matlab software. Times are presented
for different levels of absolute risk-aversion given 6 aggregation categories (K = 6). Times are also presented for
different numbers of aggregation categories given absolute
risk-aversion, Ra, equal to two. Figure 11 reveals that the
time required to run the SC model is positively correlated
with K and Ra.
The model form that required the longest average CPU
time per quarter to converge was the multiperiod model
where Ra was set to 5 and K to 6. This model took on
average 803 seconds to converge to the optimal portfolio.
In this model, the average number of cycles before convergence over the test period was 17, looping occurred in 29%
of the model runs, and when looping did occur, an average
of 1.75 branches were necessary to end the loop. This particular model was also the largest in size with 337 variables
and 185 constraints. The comparable SP model with no

473

aggregation given 3,000 scenarios would be 156,025 variables and 84,017 constraints.
4. CONCLUSIONS
SC provides a new, dynamic and reliable decision framework of practical value for those involved in portfolio selection. The technique permits the evaluation of the problem
under a realistic assumption set with minimal technological
requirements. SC is appropriate not only in deriving new
portfolio plans but in evaluating current portfolio plans and
identifying revisions that would lead to improved performance. The inclusion of uncertainty in all stochastic parameters and the maximization of performance over any length
planning horizon are both feasible in SC. In addition, the
decision maker is not limited in the form of risk metric
used or the types of side constraints necessary to model
special portfolio requirements.
Simulated tests show that SC, with scenario aggregation,
generates portfolios exhibiting performance similar to those
generated using SP with no aggregation. Single-period SC
models with as few as two aggregation categories compare
favorably to SP models using both in-sample and holdout
out-sample scenarios. A comparison of model forms in
a risk-return framework reveals that SC portfolio risk
approaches that realized using SP as the number of aggregation categories increases. SC portfolios with aggregation
are, however, not dominated by SP portfolios and clearly
dominate mean-variance efcient (MV) portfolios.
Empirical tests using historical fund returns over an
extended test horizon illustrate that using a multiperiod
SC strategy to select portfolio plans results in performance
that is superior to that of holding individual broad-based
funds or of employing various benchmark or MV strategies.
This is particularly evident when asset-liability management models forms are compared relative to value at risk
(VaR). Multiperiod models also clearly dominate myopic
models in the rolling time horizon tests. The inability to
incorporate rebalancing costs in a single-period framework
results in portfolio plans the exhibit substandard performance. Computational requirements of the SC models are
minimal.
Finally, there are two important practical features of SC.
First, SC permits focused aggregation on low end performance allowing for control of risk in a preferred lower partial variance context; this is not feasible in nonaggregated
formats making the implementation of models controlling
for only low end variability difcult, if not impossible, in
SP. Second, SC model size is independent of the number of
scenarios and, therefore, not a factor in solution generation.
This implies that SC can be implemented on virtually any
computing platform and the models structural form need
not adhere to requirements necessary for decomposition as
in SP. This has not been the case in the past and has been
a signicant drawback in the implementation of stochastic
models for portfolio selection.

474

/ Puelz

APPENDIX A: CONDITIONS NECESSARY

FOR SC MODEL CONVERGENCE TO A GLOBAL
OPTIMUM SOLUTION

The Hessian of the SC model objective function, Z = Kk=1 k Uk (where Uk = U wk ), is

K

$2U
$2
 k 2 1 k + Uk 2 1 k +
$ x1 1
$ x1 1
k=1

$k $Uk

2 1
1

$x1 1 $x1
1

H =
K


$2U
$2

k j k 1 + U k j k 1 +

k=1 $xi t $x1 1

$xi t $x1 1

$k $Uk
$k $Uk

+ 1

j
1

$x1 1 $xij t
$xi t $x1
1

H is a square R by R symmetric matrix where R is the

number of asset allocation decision variables. For simplicity elements in H are referred to as aij where aij is
the element in the ith row and jth column. The objective
function is assumed to have continuous second-order par1
K
tial derivatives for each X = x1
1 xM T ,) which is an
element of the feasible set S. The objective can be shown
to be a concave function on the feasible set S if the nth
principal minor of H has the same sign as 1n .
The rst principal minors (aii s or principal diagonal elements) of H are negative if the following conditions hold:
$ 2 Uk
j

$ 2 xi t
$ 2 k
j

$ 2 xi t

<0

i = 1 to M, k = 1 to K
j = 1 to K, t = 1 to T 

<0

$xi t $xi t

$xi t

K


$k
k=1

$xit

k

1
$xi t $x1
1

j = 1 to K t = 1 to T 
0

$Uh
j

$xi t
=0

1
$xi t $x1
1

$k $Uk
$ $Uk
+ 1k
j
j
1
$xi t $x1 1 $x1 1 $xi t

K


k=1

k

$ 2 Uk
j

$ 2 xi t
2

+ Uk

$ 2 k
j

$ 2 xi t

$k $Uk
j

$ 2 xi t $ 2 xi t

(A.4) implies that if an increase in the holding of asset

i will increase (decrease) overall investor utility, then the
aggregate utility, for each class k should also increase
(decrease) uniformly across aggregation categories. (A.5)
holds by denition.
The nth order principal minors for n > 1 will have the
sign of 1n if
pjj < 0

j = 1 to n

(A.6)

where
p1 j = a1 j 

(A.6a)

u1 i = p1 i /p1 1 

(A.6b)

pi j = ai j u1 i p1 j + u2 i p2 j
+ + ui1 i pi1 j  and

(A.6c)

(A.2)

13

(A.6d)

i = 1 to M
j = 1 to K, t = 1 to T

+ Uk

$ 2 k

(A.1)

(A.3)

(A.1) and (A.2) are supported in that the impact a change

j
j
in xi t has on either k or Uk is diminishing in xi t . This is
because the greater the amount held of an asset i, the more
highly correlated portfolio returns are with the return on
asset i. The higher the correlation between an asset i and
portfolio returns the smaller the adjustments to k and Uk
in the simulation phase of the SC model.
Condition (A.3) requires that the following:
$Uk

k=1

$ 2 Uk

i = 1 to M, k = 1 to K

K


$k $Uk
k=1

K

i = 1 to M, j = 1 to K, k = 1 to K
h = 1 to K, h = k, t = 1 to T

(A.4)

i = 1 to M j = 1 to K t = 1 to T

(A.5)

ui i = pi i /pi i

The term pjj can be described as the change in the marginal

impact asset j has on expected utility given a change in
asset js allocation (ajj ), less the proportion of the marginal
impact that can be accounted for jointly by assets 1 through
j 1 (the term in parentheses in (A.6c)). In other words, pjj
can be thought of as the unique marginal effect on expected
utility for a change in asset js allocation.
APPENDIX B: MODIFIED BRANCH AND BOUND
ALGORITHM FOR TERMINATION OF LOOPS
IN THE SC MODEL
When the SC model begins looping between a set of portfolios, two portfolios are selected from the loop and the
following steps are taken:
1. The difference between the rst-period asset allocation decision variables (xi1 1 ) for the two selected portfolios
is calculated.

Puelz
2. The asset with the largest absolute value difference is
selected as the branching asset.
3. A less than constraint is added to the model for the
selected branching asset. The RHS value is the maximum
value that will result in no change in the branching decision
variable from cycle to cycle. The model is restarted.
4. If the model converges after the addition of the constraint in Step 3, then the constraint is multiplied by 1
and the model restarted.
5. If the model does not converge at either Step 3 or
Step 4, then a new branching constraint is added in Step 1
and the process continues.
Branches are pruned (terminated) if the objective function value for any solution in the loop is less than the
current best converged solution objective function value.
Pruning branches will not eliminate superior solutions,
as the converged solution resulting from the addition a
branching constraint will always be inferior to those solutions in the loop prior to the addition of the branching constraint. Branches are added and pruned in this manner until
an exhaustive search of the solution space is accomplished.
The converged solution with the highest objective function
value is the optimal solution.
ENDNOTES
1

In some cases it might be appropriate to run SC with

several initial portfolio plans. This is the case when the
conditions necessary for the model convergence to a global
optimum are violated. In these cases SC can be considered a portfolio improvement model and will generate portfolios that improve upon the initial portfolio plan. See
Appendix A for a detailed description of conditions necessary for convergence to a global optimum.
2
The SC approach can be implemented using any technique for the generation of random returns. For example,
if xed-income securities alone comprise the asset selection set, an arbitrage-free term structure model would be
appropriate for scenario generation (Zenios 1991, Hiller
and Eckstein 1993). If non xed-income securities are to
be included in the selection set, the use of principal component analysis could be employed (Mulvey and Vladimirou
1989).
3
As long as the rst derivative of rst-period return
relative to ending wealth is different from zero, aggregating
based on rst-period wealth in SC will result in a portfolio
that maximizes the utility of ending wealth given that the
general conditions set forth in Appendix A are met. This
is true regardless of the level of mean reversion of returns
over the planning horizon.
4
In empirical tests the median is used to divide scenarios into above and below average performance. In general, however, to focus on poor performing outcomes, most
aggregation categories should be used to separate low
wealth outcomes where the variability of returns is critical
and fewer categories are used to separate high wealth outcomes.

475

For example, consider again a callable bond. The rst

aggregation step would be to divide the scenarios into two
categories, those where the bond would be called and those
where it would not be called. Within each of these initial categories additional aggregation would be conducted
given wealth under each scenario. Under this scheme the
condition specied in (A.4) and (A.5) are satised. The
same approach could be applied to any instrument that
exhibits different return behavior determined by external
factors such as interest rates.
6
Two limitations of applying quadratic utility are that

U wk  < 0 for wk > wmax and Ra wk  > 0.
7
Negative returns over the planning horizon result
when the cost of the liability over the planning horizon is
greater then the portfolio return.
8
Certainly other procedures could be employed to generate data realizations for uncertain returns. PCA was
chosen for these tests because it reduces the dimensionality
of the forecasting problem and is a reasonable technique for
capturing the correlation between uncertain parameters over
a short planning horizon. Mulvey and Vladimirou (1989)
provide a detailed description of the process for generating
returns using PCA.
9
Two limitations of applying quadratic utility are that

U wk  < 0 for wk > wmax and Ra wk  > 0. The rst limitation U wk  < 0 for wk > wmax is actually less of a
problem with scenario aggregation when high level wealth
categories are aggregated into a single large category (see
Figure 5). The more scenarios aggregated into the high
wealth category the greater the probability that wk < wmax
and U wk  > 0 for all wk . The second limitation is that
Ra wk  > 0 rather than Ra being a decreasing function of
w as plausible utility theory would suggest (Pratt 1964).
Kallberg and Ziemba (1983), however, provide strong
empirical evidence that over time horizons of less than one
year different forms of utility (including quadratic) result
in similar optimal portfolio choices. They suggest that for
purposes of tractable solution procedures, quadratic utility
is a reasonable surrogate for more plausible forms of utility.
It is reasonable to assume the performance results provided
in these tests are robust across utility function forms.
10
Applying a constant Ra relative to wo over time
implies that the cash equivalent for risk at initial wealth
is the same over time rather than increasing (decreasing)
as initial wealth increases (decreases) as utility theory suggests if utility remains constant over time. Because the outcome of these tests is a comparison of portfolio performance in a general risk/return framework and no attempt
is made to compare mean return across set levels of Ra,
this assumption has no impact on the conclusions drawn
in these tests. Holding Ra constant eliminates the need to
arbitrarily redene absolute risk-aversion at the beginning
of each period in the test.
11
The short-term risk-free asset (cash) has a return
equal to the three-month t-bill.

476

/ Puelz
12

All SC models in this set of comparisons used 6

aggregation categories (K = 6).
13
n The determinant of a symmetric matrix is dened as
j=1 pjj using Forward Doolittles Scheme.

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