A higher order portfolio optimization model incorporating information entropy

Abstract

This paper expands the model for higher-order moments (evolving into an MVSK model with skewness and kurtosis analysis) and compares it to the classic quadratic objective function of Markowitz. Along with the MVSK analysis, we add an information entropy variable to the model taking into account the asset's informational efficiency and diversity, and trying to encompass the high uncertainty intrinsic to the market's returns and increase the model's validity. We analyze the practical effectiveness and the complexity of creating such a multi-objective portfolio model to see if we can provide more information to the investor with the new framework.

Keywords

• Modern Portfolio Theory
• Mean-variance
• Markowitz
• MVSK model
• MVSKE portfolio
• Information entropy