OPTIMAL PORTFOLIO SELECTION WITH A SHORTFALL PROBABILITY CONSTRAINT: EVIDENCE FROM ALTERNATIVE DISTRIBUTION FUNCTIONS

We propose a new approach to optimal portfolio selection in a downside risk framework that allocates assets by maximizing expected return subject to a shortfall probability constraint, reflecting the typical desire of a risk‐averse investor to limit the maximum likely loss. Our empirical results indicate that the loss‐averse portfolio outperforms the widely used mean‐variance approach based on the cumulative cash values, geometric mean returns, and average risk‐adjusted returns. We also evaluate the relative performance of the loss‐averse portfolio with normal, symmetric thin‐tailed, symmetric fat‐tailed, and skewed fat‐tailed return distributions in terms of average return, risk, and average risk‐adjusted return.