A dynamic portfolio theory model based on minimum semi‐absolute deviations criterion with an application in the Chinese stock markets

Abstract

PurposeThe purpose of this paper is to prove the effectiveness of minimum semi‐absolute deviations (MSAD) method in dynamic portfolio investment.Design/methodology/approachIn financial investment, the classical static portfolio theory of Markowitz type lacks the dynamic adaptability to the changing market situations. This paper proposes a dynamic portfolio theory which uses MSAD criterion on a moving window to replace the Markowitz mean‐variance analysis.FindingsTwo specific models are developed to test the validity of the MSAD method: the first model constructs a portfolio consisting of Shanghai‐Shenzhen 300 Index and a national debt as two contrarian assets; the second model constructs a portfolio consisting of a complete set of 18 Chinese stock sector indices and a national debt. The empirical results of the test using six‐year monthly data (2005 to 2010) provide significant evidence that the MSAD method is valid, producing superior returns of investment over the stock index during the test period.Research limitations/implicationsThe findings in this study clearly highlight the validity of the MSAD method in determining the weights of assets in Chinese stock markets.Practical implicationsIn order to resolve the problem of portfolio investment in Chinese stock markets, the MSAD method with stop loss control strategy can be used for investors to obtain the weights of assets and control the risk.Originality/valueThis study analyzes and verifies the effectiveness of the MSAD method in dynamic portfolio investment. The stop loss control strategy designed and used in the MSAD method is a pioneering and exploratory experiment.