An Automated Decision Support System for Portfolio Allocation Based on Mutual Information and Financial Criteria
This paper introduces a two-phase decision support system based on information theory and financial practices to assist investors in solving cardinality-constrained portfolio optimization problems. Firstly, the approach employs a stock-picking procedure based on an interactive multi-criteria decisio...
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2025-04-01
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| author | Massimiliano Kaucic Renato Pelessoni Filippo Piccotto |
| author_facet | Massimiliano Kaucic Renato Pelessoni Filippo Piccotto |
| author_sort | Massimiliano Kaucic |
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| description | This paper introduces a two-phase decision support system based on information theory and financial practices to assist investors in solving cardinality-constrained portfolio optimization problems. Firstly, the approach employs a stock-picking procedure based on an interactive multi-criteria decision-making method (the so-called TODIM method). More precisely, the best-performing assets from the investable universe are identified using three financial criteria. The first criterion is based on mutual information, and it is employed to capture the microstructure of the stock market. The second one is the momentum, and the third is the upside-to-downside beta ratio. To calculate the preference weights used in the chosen multi-criteria decision-making procedure, two methods are compared, namely equal and entropy weighting. In the second stage, this work considers a portfolio optimization model where the objective function is a modified version of the Sharpe ratio, consistent with the choices of a rational agent even when faced with negative risk premiums. Additionally, the portfolio design incorporates a set of bound, budget, and cardinality constraints, together with a set of risk budgeting restrictions. To solve the resulting non-smooth programming problem with non-convex constraints, this paper proposes a variant of the distance-based parameter adaptation for success-history-based differential evolution with double crossover (DISH-XX) algorithm equipped with a hybrid constraint-handling approach. Numerical experiments on the US and European stock markets over the past ten years are conducted, and the results show that the flexibility of the proposed portfolio model allows the better control of losses, particularly during market downturns, thereby providing superior or at least comparable ex post performance with respect to several benchmark investment strategies. |
| format | Article |
| id | doaj-art-5e90e090af89433fa69127a3ca411283 |
| institution | DOAJ |
| issn | 1099-4300 |
| language | English |
| publishDate | 2025-04-01 |
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| spelling | doaj-art-5e90e090af89433fa69127a3ca4112832025-08-20T03:14:36ZengMDPI AGEntropy1099-43002025-04-0127548010.3390/e27050480An Automated Decision Support System for Portfolio Allocation Based on Mutual Information and Financial CriteriaMassimiliano Kaucic0Renato Pelessoni1Filippo Piccotto2Department of Economic, Business, Mathematical and Statistical Sciences, University of Trieste, 34127 Trieste, ItalyDepartment of Economic, Business, Mathematical and Statistical Sciences, University of Trieste, 34127 Trieste, ItalyDepartment of Economic, Business, Mathematical and Statistical Sciences, University of Trieste, 34127 Trieste, ItalyThis paper introduces a two-phase decision support system based on information theory and financial practices to assist investors in solving cardinality-constrained portfolio optimization problems. Firstly, the approach employs a stock-picking procedure based on an interactive multi-criteria decision-making method (the so-called TODIM method). More precisely, the best-performing assets from the investable universe are identified using three financial criteria. The first criterion is based on mutual information, and it is employed to capture the microstructure of the stock market. The second one is the momentum, and the third is the upside-to-downside beta ratio. To calculate the preference weights used in the chosen multi-criteria decision-making procedure, two methods are compared, namely equal and entropy weighting. In the second stage, this work considers a portfolio optimization model where the objective function is a modified version of the Sharpe ratio, consistent with the choices of a rational agent even when faced with negative risk premiums. Additionally, the portfolio design incorporates a set of bound, budget, and cardinality constraints, together with a set of risk budgeting restrictions. To solve the resulting non-smooth programming problem with non-convex constraints, this paper proposes a variant of the distance-based parameter adaptation for success-history-based differential evolution with double crossover (DISH-XX) algorithm equipped with a hybrid constraint-handling approach. Numerical experiments on the US and European stock markets over the past ten years are conducted, and the results show that the flexibility of the proposed portfolio model allows the better control of losses, particularly during market downturns, thereby providing superior or at least comparable ex post performance with respect to several benchmark investment strategies.https://www.mdpi.com/1099-4300/27/5/480mutual informationportfolio optimizationrisk budgetingDISH-XXknowledge-based financial management system |
| spellingShingle | Massimiliano Kaucic Renato Pelessoni Filippo Piccotto An Automated Decision Support System for Portfolio Allocation Based on Mutual Information and Financial Criteria Entropy mutual information portfolio optimization risk budgeting DISH-XX knowledge-based financial management system |
| title | An Automated Decision Support System for Portfolio Allocation Based on Mutual Information and Financial Criteria |
| title_full | An Automated Decision Support System for Portfolio Allocation Based on Mutual Information and Financial Criteria |
| title_fullStr | An Automated Decision Support System for Portfolio Allocation Based on Mutual Information and Financial Criteria |
| title_full_unstemmed | An Automated Decision Support System for Portfolio Allocation Based on Mutual Information and Financial Criteria |
| title_short | An Automated Decision Support System for Portfolio Allocation Based on Mutual Information and Financial Criteria |
| title_sort | automated decision support system for portfolio allocation based on mutual information and financial criteria |
| topic | mutual information portfolio optimization risk budgeting DISH-XX knowledge-based financial management system |
| url | https://www.mdpi.com/1099-4300/27/5/480 |
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