Wealth management: Modeling the nonlinear dependence

Abstract

This work aims at the development of an enhanced portfolio selection method, which is based on the classical portfolio theory proposed by Markowitz (1952) and incorporates the local Gaussian correlation model for optimization. This novel method of portfolio selection incorporates two assumptions: the non-linearity of returns and the empirical observation that the relation between assets is dynamic. By selecting ten assets from those available in Yahoo Finance from S&P500, between 1985 and 2015, the performance of the new proposed model was measured and compared to the model of portfolio selection of Markowitz (1952). The results showed that the portfolios selected using the local Gaussian correlation model performed better than the traditional Markowitz (1952) method in 63 of the cases using block bootstrap and in 71 of the cases using the standard bootstrap. Comparing the calculated Sharpe ratios, the proposed model yielded a better adjusted risk-return in the majority of the cases studied.