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A simheuristic algorithm for the portfolio optimization problem with random returns and noisy covariances

A simheuristic algorithm for the portfolio optimization problem with random returns and noisy covariances
A simheuristic algorithm for the portfolio optimization problem with random returns and noisy covariances
The goal of the portfolio optimization problem is to minimize risk for an expected portfolio return by allocating weights to included assets. As the pool of investable assets grows, and additional constraints are imposed, the problem becomes NP-hard. Thus, metaheuristics are commonly employed for solving large instances of rich versions. However, metaheuristics do not fully account for random returns and noisy covariances, which renders them unrealistic in the presence of heightened uncertainty in financial markets. This paper aims to close this gap by proposing a simulation–optimization approach – specifically, a simheuristic algorithm that integrates a variable neighborhood search metaheuristic with Monte Carlo simulation – to deal with stochastic returns and noisy covariances modeled as random variables. Computational experiments performed on a well-established benchmark instance illustrate the advantages of our methodology and analyze how the solutions change in response to a varying degree of randomness, minimum required return, and probability of obtaining a return exceeding an investor-defined threshold.
Biased randomization, Constrained portfolio optimization, Financial assets, Metaheuristics, Simulation, Variable neighborhood search
0305-0548
Kizys, Renatas
9d3a6c5f-075a-44f9-a1de-32315b821978
Doering, Jana
c8b6e354-b54f-415b-8873-805cb1b7e8ea
Juan, Angel A.
681f726e-e136-4028-816e-927f41c326d3
Polat, Onur
962fa86e-1453-4346-b040-8146fb527197
Calvet, Laura
0c8e51bc-5ec3-469b-a8ab-cb2b1c760c33
Panadero, Javier
70cf8175-0e95-4239-9800-2732f8cfbb62
Kizys, Renatas
9d3a6c5f-075a-44f9-a1de-32315b821978
Doering, Jana
c8b6e354-b54f-415b-8873-805cb1b7e8ea
Juan, Angel A.
681f726e-e136-4028-816e-927f41c326d3
Polat, Onur
962fa86e-1453-4346-b040-8146fb527197
Calvet, Laura
0c8e51bc-5ec3-469b-a8ab-cb2b1c760c33
Panadero, Javier
70cf8175-0e95-4239-9800-2732f8cfbb62

Kizys, Renatas, Doering, Jana, Juan, Angel A., Polat, Onur, Calvet, Laura and Panadero, Javier (2022) A simheuristic algorithm for the portfolio optimization problem with random returns and noisy covariances. Computers & Operations Research, 139, [105631]. (doi:10.1016/j.cor.2021.105631).

Record type: Article

Abstract

The goal of the portfolio optimization problem is to minimize risk for an expected portfolio return by allocating weights to included assets. As the pool of investable assets grows, and additional constraints are imposed, the problem becomes NP-hard. Thus, metaheuristics are commonly employed for solving large instances of rich versions. However, metaheuristics do not fully account for random returns and noisy covariances, which renders them unrealistic in the presence of heightened uncertainty in financial markets. This paper aims to close this gap by proposing a simulation–optimization approach – specifically, a simheuristic algorithm that integrates a variable neighborhood search metaheuristic with Monte Carlo simulation – to deal with stochastic returns and noisy covariances modeled as random variables. Computational experiments performed on a well-established benchmark instance illustrate the advantages of our methodology and analyze how the solutions change in response to a varying degree of randomness, minimum required return, and probability of obtaining a return exceeding an investor-defined threshold.

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Stochastic_Portfolio_Optimisation - Accepted Manuscript - Accepted Manuscript
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More information

Accepted/In Press date: 8 November 2021
e-pub ahead of print date: 20 November 2021
Published date: 1 March 2022
Keywords: Biased randomization, Constrained portfolio optimization, Financial assets, Metaheuristics, Simulation, Variable neighborhood search

Identifiers

Local EPrints ID: 453841
URI: http://eprints.soton.ac.uk/id/eprint/453841
ISSN: 0305-0548
PURE UUID: a14f9836-b4af-4501-a361-d7230477d224
ORCID for Renatas Kizys: ORCID iD orcid.org/0000-0001-9104-1809

Catalogue record

Date deposited: 25 Jan 2022 17:38
Last modified: 28 Apr 2022 02:27

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Contributors

Author: Renatas Kizys ORCID iD
Author: Jana Doering
Author: Angel A. Juan
Author: Onur Polat
Author: Laura Calvet
Author: Javier Panadero

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