Portfolio Analysis Based on Markowitz Stochastic Dominance Criteria: A Behavioral Perspective

Abstract

This paper develops stochastic optimization problems for describing and analyzing behavioral investors with Markowitz Stochastic Dominance (MSD) preferences. Specifically, we establish dominance conditions in a discrete state-space to capture all reverse S-shaped MSD preferences as well as all subjective decision weights generated by inverse S-shaped probability weighting functions. We demonstrate that these dominance conditions can be admitted as linear constraints into the stochastic optimization problems to formulate computationally tractable mixed-integer linear programming (MILP) models. We then employ the developed MILP models in financial portfolio analysis and examine classic behavioral factors such as reference point and subjective probability distortion in behavioral investors' portfolio decisions.