Applications of Stochastic Portfolio Theory

Abstract

In the previous chapters we have seen a number of theoretical applications of stochastic portfolio theory; in this chapter we shall consider some practical applications. As a first application, we show how the first-order model can be used in portfolio optimization. Next, we discuss a passive strategy based on a D _p -weighted version of the S&P 500 Index that has been used for institutional accounts since 1996. Manager performance is related to the change in market diversity, and we analyze this relationship and consider its implications. We propose a direct method to measure the effect that changes in the distribution of capital have on portfolio return, and use this method to analyze the poor performance of value stocks during the 1990s. Our analysis indicates that the principal cause of this disappointing performance was a shift in the capital distribution that favored the larger stocks over the period considered.