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 European Journal of Operational Research 207 (2010) 409–419

Contents lists available at ScienceDirect

European Journal of Operational Research

journal homepage: www.elsevier.com/locate/ejor

Decision Support

Risk management strategies via minimax portfolio optimization

George G. Polak a, David F. Rogers b,*, Dennis J. Sweeney b
a
Department of Information Systems and Operations Management, Raj Soin College of Business, Wright State University, Dayton, OH 45435-0001, USA
b
Department of Quantitative Analysis and Operations Management, College of Business, University of Cincinnati, Cincinnati, OH 45221-0130, USA

a r t i c l e i n f o a b s t r a c t

Article history: Recent extreme economic developments nearing a worst-case scenario motivate further examination of
Received 29 March 2009 minimax linear programming approaches for portfolio optimization. Risk measured as the worst-case
Accepted 27 April 2010 return is employed and a portfolio from maximizing returns subject to a risk threshold is constructed.
Available online 6 May 2010
Minimax model properties are developed and parametric analysis of the risk threshold connects this
model to expected value along a continuum, revealing an efficient frontier segmenting investors by risk
Keywords: preference. Divergence of minimax model results from expected value is quantified and a set of possible
Investment analysis
prior distributions expressing a degree of Knightian uncertainty corresponding to risk preference deter-
Risk analysis
Risk management
mined. The minimax model will maximize return with respect to one of these prior distributions provid-
Knightian uncertainty ing valuable insight regarding an investor’s risk attitude and decision behavior. Linear programming
Linear programming models for financial firms to assist individual investors to hedge against losses by buying insurance
and a model for designing variable annuities are proposed.
 2010 Elsevier B.V. All rights reserved.

1. Introduction slow and moderate economic changes. But, when extreme

Risk-taking typically accompanies economic gain for an individ-
ual Decision Maker (DM) who is choosing from several potential
alternative investments. The realized return depends upon uncon-
trollable states of nature that may occur in the future. A preference
for high returns must be balanced against the desire for managing
the risk inherent in the states of nature that are assumed to be
completely beyond the control of the DM. How one defines and
measures risk is fundamental to selecting an appropriate approach
to probabilistic decision-making. Here, a straightforward approach
to modeling risk – the worst-case return for a decision strategy –
along with similar modeling approaches for a financial services
firm, are developed. Such a firm typically can assume more risk
than the DM and provides additional investment capital when it
is mutually beneficial with the DM.
Attention to risk as measured by worst-case results is very
timely given the current economic ‘‘house of cards” that developed
as financial firms insured each other but with insufficient collat-
eral, using an estimated $60 trillion in credit default swaps. Indeed
other typical objectives such as minimizing variation or the popu-
lar value-at-risk objective may be quite effective during periods of
* Corresponding author. Address: Department of Quantitative Analysis and
Operations Management, College of Business, University of Cincinnati, 2925
Campus Green Drive, P.O. Box 210130, Cincinnati, OH 45221-0130, USA. Tel.: +1
513 556 7143; fax: +1 513 556 5499.
E-mail addresses: George.Polak@Wright.edu (G.G. Polak), David.Rogers@UC.edu
(D.F. Rogers), Dennis.Sweeney@UC.edu (D.J. Sweeney).
economic developments that have been close to the worst-case
scenario such as those during the financial collapses of many
international financial firms in 2008 occur, investors may prefer
to be much more conservative. Hence, the scrutiny of worst-case
analyses has become more relevant and timely.
For some basic investment decision-making approaches, the
DM may be restricted to choosing only one of a discrete number
of alternatives. For other scenarios, a diversified portfolio com-
prised of a convex combination of two or more alternatives may
be feasible and will often better balance risk and return. Sharpe
(1971) stated that ‘‘if the essence of the portfolio analysis problem
could be adequately captured in a form suitable for linear pro-
gramming methods, the prospect for application would be greatly
enhanced”. Linear programming (LP) affords the DM the opportu-
nity to determine an optimal balance between risk and return for
modeling portfolio optimization problems with diversification
among alternatives. We consider an LP model for maximizing the
minimum return in response to this methodological challenge as
the point of departure.
Young (1998) formulated an LP for maximizing the minimum
return to select a diversified portfolio based on historical returns
data. He referred to the LP as a ‘‘minimax” model because of its
greater familiarity and this convention will be followed. The per-
formance of the model was compared to other similar linear and
nonlinear models and statistical analyses and simulation were
employed to find that the minimax approach outperformed the
mean–variance approach with respect to mean square estimation
error under the widely used log-normal distribution. He showed

0377-2217/$ - see front matter  2010 Elsevier B.V. All rights reserved.
doi:10.1016/j.ejor.2010.04.025
410 G.G. Polak et al. / European Journal of Operational Research 207 (2010) 409–419
the minimax modeling approach to be compatible with expected
utility maximization and explored the incorporation of fixed
transaction charges. We proceed by establishing results about
the risk-return tradeoff inherent in the minimax model and show
that parametric analysis of the optimal LP solution with respect to
the risk threshold connects this model to the Expected Value (EV)
rule along a continuum. This reveals an efficient frontier and seg-
ments the market of investors for a financial services firm.
Lagrangian relaxation is used in a novel way to determine a con-
vex polyhedral set of multiple possible prior distributions that
corresponds to a DM’s choice of risk threshold. In this way we link
risk aversion to ambiguity about the likelihood of the states of
nature. This in turn leads to an alternative probability distribution
termed the surrogate prior, which quantifies the divergence of the
LP model from the EV rule and provides a financial services firm
valuable insight regarding a DM’s risk attitude and decision
behavior. Additionally, it will be shown how LP duality and
post-optimality can guide a financial services firm in making deci-
sions about partnering with a DM and how the models can be
modified to incorporate insurance decisions for both the DM
and financial services firm.
In Section 2 is a literature review of research for LP models for
making portfolio decisions and insurance decisions. Section 3 con-
tains the decision framework preamble and basic minimax model-
ing approaches and properties. In Section 4 it is shown how
financial services firms can employ duality and post-optimality
to assist them in making investment decisions. Insurance models
for both the DM and a financial services firm are presented in Sec-
tion 5. In Section 6 the LP model is adapted to design a financial
product much like the typical variable annuity. In Section 7 are
illustrations of the models using real data and conclusions and fu-
ture research directions are presented in Section 8.
2. Literature review
There is a vast literature devoted to the balancing of risk and
return in financial markets. The most celebrated of these is the
approach of Markowitz (1952, 1991) where a quadratic mean–
variance model with risk measured by the covariance matrix of
returns was developed. But Konno and Yamazaki (1991) noted
that the derivation of the covariance matrix can be cumbersome,
attempting to solve a quadratic model has computational limita-
tions in practice, and the optimal solution may consist of pur-
chasing a large number of stocks. They suggested employing
linear objectives to alleviate these computational limitations. In
spite of the fact that Sharpe (1963) developed a methodology
for practical solution of the quadratic objective, many approaches
have been taken to linearize the model. Sharpe (1967, 1971) and
Stone (1973) both showed how the quadratic model could be
transformed to an equivalent model with a separable quadratic
function making it much easier to solve with linear approxima-
tion approaches.
Biglova et al. (2004) identified several other criteria for estimat-
ing portfolio theory risk that can be employed in LP models instead
of the covariance risk measure of Markowitz (1952, 1991). Among
these include Gini’s mean absolute difference as incorporated by
Yitzhaki (1982) resulting in a LP for constructing efficient portfo-
lios. In their linear optimization model, Konno (1990) and Konno
and Yamazaki (1991) employed absolute deviation rather than
covariance to measure the risk. They solved a problem with 224
stocks over 60 months on a real-time basis and found results
similar to that of the mean–variance model but requiring much
less computational effort. Speranza (1993) generalized this
approach using a risk function that is a linear combination of
two semi-absolute deviations of return from the mean.
Ogryczak (2000) formulated and solved a multi-criteria LP con-
sisting of one objective for each time period and showed the
mean–variance approach of Markowitz (1952, 1991), the absolute
deviation approach of Konno and Yamazaki (1991), and the mini-
max approach of Young (1998) to be special cases. Cai et al.
(2000) considered an objective of minimizing the expected abso-
lute deviation of the future returns from their mean for several as-
sets and found that the problem could be solved analytically rather
than solving a LP model. Similarly, Teo and Yang (2001) minimized
the average of maximum individual risks over a number of time
periods and the resulting optimization model was found to be solv-
able as a bi-criteria piecewise LP problem. Benati (2003) replaced
the covariance objective of Markowitz (1952, 1991) with the worst
conditional expectation resulting in a LP and developed an efficient
algorithm for practical solutions to real-world sized problems.
Ding (2006) considered LP models for maximizing the minimum
returns but without the constraint for a minimum required aver-
age return for the portfolio as in Young (1998). For these simpler
LP models he was able to develop optimal control policies for four
cases of assumptions regarding evaluations/forecasts for the po-
tential returns. Gülpınar and Rustem (2007) proposed multiple
alternative return and risk scenarios and developed a min–max
algorithm to determine an optimal worst-case investment
strategy.
Rockafellar and Uryasev (2000), Krokhmal et al. (2002), and
Mansini et al. (2007) all focused upon minimizing conditional va-
lue-at-risk and developed LP models, properties, and solution ap-
proaches for this setting. Schrage (2001) devoted a chapter to
portfolio optimization featuring a LP model to maximize the min-
imum return and another to minimize expected downside risk. His
wide-ranging treatment of this topic also included approximations
for the covariance matrix, inclusion of transaction costs, and inclu-
sion of taxes for the Markowitz (1952, 1991) model as well as the
value-at-risk model and several deterministic equivalents of other
stochastic optimization models. Alexander and Baptista (2004)
incorporated value-at-risk and conditional value-at-risk as con-
straints in the Markowitz (1952, 1991) model and found the con-
ditional value-at-risk approach dominant for managing risk.
Benati and Rizzi (2007) formulated an integer linear programming
model with value-at-risk replacing the covariance for the objective
and developed properties for which polynomial time algorithms
exist. Mansini et al. (2003a,b) provided a systematic overview, dis-
cussion of properties, and a computational comparison for LP solv-
able models for portfolio selection.
Some of the insurance-related models in this article were in-
spired by the work of Kahneman and Tversky (1979) who thor-
oughly examined underweighting and overweighting of
probabilities as key issues that may make insurance against losses
attractive. Approaches for insurance modeling began with Leland
(1980) and Brennan and Solanki (1981) who examined maximizing
expected utility subject to a budget constraint. But investor’s pref-
erences and probability beliefs may be difficult to ascertain and
analyze so Aliprantis et al. (2000) introduced a LP approach to min-
imize the cost of a portfolio subject to a minimal payoff. Katsikis
(2007) further refined computational approaches for this model.
Aliprantis et al. (2002) extended the LP model by taking advantage
of the situation where portfolio dominance information is also
available.
Finally, we also consider the management of ambiguity con-
cerning prior probabilities and that topic has been the focus of an-
other significant stream of research. Gilboa and Schmeidler (1989)
employed a set of multiple prior probability distributions to model
situations where the DM has too little information to discern a sin-
gle prior distribution and expressed investor preferences as a util-
ity function over this set. Chateauneuf et al. (2005) developed
theoretical underpinnings for a number of important applications
 G.G. Polak et al. / European Journal of Operational Research 207 (2010) 409–419 411

of the multiple priors. Gajdos et al. (2004) introduced a partial nature may solve the following diversified LP model henceforth
order on the set of multiple priors based on a reference prior called the ‘‘minimax” model as in Young (1998).
distribution within the set termed an anchor. They proceeded to
LPðMÞ Max zM ¼ n; ð1Þ
show that a DM who is averse to information imprecision tends
to maximize the minimum expected utility with respect to a sub- Xm
s:t: n6 rij vi for j 2 f1; . . . ; ng; ð2Þ
set of the multiple priors. Garlappi et al. (2007) employed confi- i¼1
dence intervals around estimated expected returns to reflect X
m
decision-making under multiple priors and modeled ambiguity vi 6 1; ð3Þ
aversion in terms of minimization of a function over these priors. i¼1

vi P 0; 8 i 2 f1; . . . ; mg: ð4Þ

3. Minimax LP models
3.1. Decision framework basics for investment modeling
For a classical non-diversified portfolio investment decision
analysis framework, the DM considers from i 2 {1, . . ., m} mutually
exclusive and collectively exhaustive investment alternatives for a
specified planning period. After a unique decision alternative has
been chosen, one of j 2 {1, . . ., n} mutually exclusive and collec-
tively exhaustive probabilistic states of nature is observed. A state
of nature can represent, for example, a set of economic circum-
stances during the planning period. For decision alternative i with
state of nature j, rij is the return, a discrete-valued random variable
expressed as a proportion of the investment and is typically repre-
sented by an element of an m  n payoff matrix.
The applicable criteria for selecting a decision alternative
depend on the quality of information about the probabilities of
the states of nature. If these probabilities are known exactly, char-
acterizing circumstances of risk in a classical sense (Rigotti and
Shannon, 2005), the EV rule is often recommended. Let ri be a
random vector representing the array of returns from decision
alternative i. Employing the EV rule results in selecting the decision
alternative(s) with the largest expected return indexed by

i ¼ arg maxfE½r i g. Alternatively, if there is vagueness about the
values ofi these probabilities, the multiple prior model proposed
by Gilboa and Schmeidler (1989) may be appropriate. If the ambi-
guity is so great that the DM has no information at all about the
likelihood of the states of nature, circumstances known as Knigh-
tian or model uncertainty (Schied, 2007), the minimax decision is
commonly considered to be a prudent choice. The index for the
best decision alternative using the minimax approach is given by
m   These probabilities can be incorporated into an enhanced opti-
i ¼ arg max minj fr ij g .
i
Even with exact probabilities a risk-averse or prudent DM may
forego the decision resulting from the EV rule for a lack of the
means or will to bear the associated risk. When possible, allowing
diversification – investing in more than one alternative – is one
way for a DM to cope with the adverse consequences that may
The optimal value for LP(M), zM , is the minimum guaranteed re-
turn for the DM and the optimal solution is the allocation of the
DM’s funds among the decision alternatives. The value for zM for
this diversified solution dominates the payoff associated with the
single maximin decision alternative indicating the value to the
DM of diversifying the investment decision problem when feasible.
LP(M) has identical properties as the primal LP formulation of
the two-person zero-sum matrix game as discussed in Murty
(1983). In this context, rij is paid by an opponent in the game.
The opponent can be considered as personifying the exogenous
financial market, or simply ‘‘nature”, and this opponent may simul-
taneously solve the dual to LP(M) to optimality. The dual to LP(M)
includes a constraint that the nonnegative dual variables sum to
one and thus comprise a probability distribution for the states of
nature with the objective being to minimize the expected value
of the portfolio with respect to this distribution. Even though
ambiguity or Knightian uncertainty is assumed where there is no
prior knowledge of the probabilities of the states of nature, the
DM has chosen a portfolio as if to maximize expected return with
respect to a worst-case probability distribution.
Alternatively, prior knowledge of the state probabilities would
free the DM from possibly taking an overly defensive posture with
respect to this worst-case distribution allowing for a more aggres-
sive approach within the realm of risk management. Suppose that
in addition to A1 we assume:
A2: Before making investment decisions, the DM knows the
prior probability distribution for the states of nature
 
pp ¼ pp1 ; . . . ; ppn . Further, E[ri] > 0 for at least one decision
or the DM will not participate in the economic activity.
mization model allowing the DM to consider maximization of the
expected return as the objective. Let q = [q1, q2, . . ., qm] be a vector
of decision variables for this new model where qi is the proportion
P
of funds to invest in decision i and E½q ¼ m i¼1 qi E½r i  ¼
Pn Pm p
j¼1 i¼1 qi pj r ij is the objective. A further assumption about the

be associated with some of the states of nature. Models for helping measure of risk allows the formulation of constraints on the min-
the DM manage risk when diversification among the decision alter- imum return in each state of nature:
natives is feasible will now be developed.
A3: The DM chooses a risk level by specifying a minimum return
‘‘risk threshold”, T, which must hold over all states of nature.
3.2. Assumptions, formulations, and properties If negative, T represents the willingness to cover a potential
loss.
The following assumption for diversification is made:
These assumptions lead to the following LP model to identify an
A1: The decision alternatives (i) and payoffs (rij) encountered by optimal diversified portfolio:
the DM are diversifiable so that a given amount of invest- LPðDMÞ Max zDM ¼ E½q; ð5Þ
ment funds can be divided among the alternatives according Xm
to any desired proportions. s:t: qi rij P T; 8 j 2 f1; . . . ; ng; ð6Þ
i¼1

Let v = [v1, v2, . . ., vm] denote a vector of decision variables X

m

where vi is the proportion of funds to invest in decision i and let

qi 6 1; ð7Þ
i¼1
n denote the minimum return from v over all j. Under A1, a conser-
vative DM without knowledge of the probabilities of the states of
qi P 0; 8 i 2 f1; . . . ; mg: ð8Þ
412 G.G. Polak et al. / European Journal of Operational Research 207 (2010) 409–419

This model was first proposed by Young (1998) except that (7) Note that L(q, k) can be simplified as follows:
is a normalization of his maximum investment portfolio constraint.
!
Objective function (5) is the expected return with respect to pp, X
m X
n X
m

and let zDM be its optimal value. Constraints (6) are for bounding Lðq; kÞ ¼ qi E½ri  þ kj rkj qk  T
i¼1 j¼1 k¼1
the return from below with risk threshold T for any state of nature !
and let aj denote the corresponding dual variable, aj its optimal va- n X
X m
p
X
n X
m

lue, and d
¼ qk p j r kj þ kj rkj qk  T
j the allowable decrease in the right-hand-side from LP
j¼1 k¼1 j¼1 k¼1
sensitivity analysis. The value chosen for T is a quantification of n X
X n   X
n
the downside risk that the DM is willing to accept with respect ¼ qk ppj þ kj rkj  T kj
to the portfolio and the specific choice of T may vary greatly by j¼1 k¼1 j¼1
investor. When T ¼ zM optimal portfolios for LP(M) and LP(DM) X
n X
m  
coincide. For values of T < zM the expected return provided by ¼ qk ppj þ kj rkj : ð12Þ
solving LP(DM) can be greater as is often the case when more risk j¼1 k¼1

can be assumed. The following theorem is a characterization of the P

The term T nj¼1 kj vanishes because of (10). A relatively small
effect of T upon zDM and an optimal portfolio, q*, and the Proof is in set of constraints that characterize Lagrange multipliers that pre-
the Appendix A. serve the dominance of q* are identified in Theorem 2 and the
Proof is in the Appendix A.
Theorem 1. For any real risk threshold T,
Theorem 2. For any instance of LP(DM), let fixed q
~ satisfy (7) and
(i) zDM is non-increasing in T; (8) and k satisfy (10) and (11) . Then
(ii) for maximizing EV with investment decision i* and for any
choice of T 6 max min fri ;j g, an optimal solution to LP(DM) Lðq; kÞ 6 Lðq
~ ; kÞ; ð13Þ
i j
is qi ¼ 1 and zDM ¼ E½r i ;
for every q satisfying (7) and (8) if and only if k satisfies
(iii) for any choice of T > zM , LP(DM) is infeasible.
X
n X
m
kj q
~ k ðr ij  r kj Þ 6 E½q
~   E½r i ; 8 i 2 f1; . . . ; mg: ð14Þ
With Theorem 1, the DM can immediately assess the potential
j¼1 k¼1
range of interesting values of T for which LP(DM) is feasible. If T
Lagrangian relaxation is employed in Theorem 2 in a novel way
is less than or equal to the minimum payoff for the EV rule deci-
to provide a set of inequalities that links risk aversion to ambiguity,
sion then LP(DM) need not be solved since an optimal decision
characterizing the set of multiple priors for risk threshold T. This
for it is identical to the one from the EV rule. If the risk threshold
set, defined as C(T) = {pp + k: k satisfies (10), (11) and (14)}, is guar-
value is greater than the optimal objective value from LP(M),
anteed to be nonempty for any T that (i) does not exceed the min-
solving LP(DM) is unnecessary since it is infeasible. Thus the
imum payoff for the EV rule decision, or (ii) is between the
assumption that T falls in the range Min ri j 6 T 6 zM will be made
j undiversified minimax return and the optimal diversified minimax
for all subsequent developments regarding LP(DM). Theorem 1
 return, as established in the following result with the Proof in the
also establishes the fact that zDM is non-increasing, consistent
Appendix A.
with the commonly-held notion that the optimal expected return
typically increases as the risk threshold decreases, i.e., an increase
in risk. An optimal dual solution to LP(DM) along with post-opti- ~ ¼ q
Corollary 1. There exists a k satisfying (10), (11) and (14) for q
mality analysis can provide valuable information to a DM or a optimal for LP(DM) given a risk threshold T such that either (i)
  
financial services firm that serves DMs as will be illustrated in T 6 max

min ri ;j or (ii) max minj frij g 6 T 6 zM .
i j i
Section 7.2.
With the existence of k now established over specified ranges of T
from Corollary 1, it may be of interest to determine a constituent
probability distribution that is in some sense closest to pp. This dis-
4. The surrogate prior tribution is p* = pp + k* where k* results from minimizing
P
kkk1 ¼ nj¼1 jkj j subject to (10), (11) and (14). The L1 norm is em-
In general an optimal solution to LP(DM), q*, does not prescribe ployed but any other appropriate norm may be employed to formu-
investments in accordance with the EV rule. But, q* can be recon- late the objective function in such an optimization model. This p* is
ciled to the latter by employing a set of multiple possible priors termed the surrogate prior distribution and it quantifies the diver-
as in Gilboa and Schmeidler (1989). To derive linear inequalities gence of the LP model from the EV rule providing a financial ser-
that characterize such a set we develop the Lagrange function by vices firm valuable insight regarding a DM’s risk attitude and
relaxing constraints (6) in LP(DM) using Lagrange multipliers decision behavior. An upper bound for kkk1 will now be derived
k = [k1, k2, . . ., kn]: and the Proof is in the Appendix A.
! Pn
X
m X
n X
m Corollary 2. An upper bound for kkk1 ¼ j¼1 jkj j is 2 Max½1  ppj .
Lðq; kÞ ¼ qk E½rk  þ kj rkj qk  T : ð9Þ
This upper bound for the norm of the surrogate prior distribu-
j

k¼1 j¼1 k¼1

tion provides a basis for measuring the relative divergence of the
optimal solution of LP(DM) from the EV rule in addition to the
Next, to ensure that the sum pp + k is a probability distribution, absolute divergence. Observe that kkk1 6 2 for any choice of a
the following must hold: probability distribution.
If k* = 0, then zDM would be identical to the maximum EV. As k*
increases in norm its magnitude is an indication of divergence of
X
n
kj ¼ 0; ð10Þ LP(DM) away from the EV rule. In this way, it quantifies a degree
j¼1 of Knightian uncertainty that corresponds to the choice of risk
 ppj 6 kj 6 1  ppj ; 8 j 2 f1; . . . ; ng: ð11Þ threshold T. A measure of relative divergence is kk k1 =2 max½1
j
pj , i.e., the ratio of the norm of the optimal Lagrange vector to
 G.G. Polak et al. / European Journal of Operational Research 207 (2010) 409–419 413

its upper bound. Also, k* is an indication of perceived probability
changes necessary for an investor to be indifferent between
LP(DM) and EV. If k* is considered to be small, the investor may
choose to forego diversification and simplify the portfolio with
fewer investments. Knowledge of p* provides a financial services
firm insights about a DM’s preferences and attitudes towards
risk-taking and gives it direction to develop and market instru-
ments accordingly. For example, a financial instrument with a high
EV with respect to p* could be very appealing to the DM.
Analyzing the vector of differences between pp and p*, k*, is sim-
ilar in spirit to the work of Budescu and Du (2007) in their exam-
ination of calibration and consistency of probability judgments
among investors. It also quantifies the overweighting and/or
underweighting of probabilities necessary for a DM to be indiffer-
ent among the investments from the optimal solution from
LP(DM) as is consistent with the work of Levy and Levy (2004).
5. Minimax models for insurance
Rather than choosing a risk threshold, the DM might cope with
investment in a single security since their financial health would
be dependent upon one investment. Other investors who employ
the simple, non-diversified maximin method may not be satisfied
with this worst-case return. For such settings a DM may turn to
a financial institution to assume risk and to make investment deci-
sions that may be diversified. Suppose there is a population of
investors who would purchase shares of an annuity comprised of
a fixed minimum return, l0, plus a variable return, l1. Return l1
is a proportion of the total return from the institutional portfolio
if the total return exceeds l0 under any state of nature. Thus, the
objective for the financial institution is to choose a portfolio that
Pm
maximizes expected net return, that is,
Pm i¼1 qi E½r i   l0 
l1 max i¼1 qi E½ri   l0 ; 0 , the expected portfolio return minus
l0, minus l1 times any return in excess of l0.
The financial institution can choose a portfolio to maximize ex-
pected net return by solving the following optimization problem
with a nonlinear objective:
( )
X
m Xm
Max qi E½ri   l1 max qi E½ri   l0 ; 0 ; ð20Þ
i¼1 i¼1

the risk of investment by turning to a financial institution to pur- X

m

chase insurance. Insurance may take the form of payments to offset s:t: qi rij  l0 P T; 8 j 2 f1; . . . ; ng; ð21Þ
i¼1
unsatisfactory returns for particular states of nature. Denote the
X
m
financial institution’s payment to the DM if outcome j occurs be qi 6 1; ð22Þ
the proportion of investment sj, j 2 {1, . . ., n}. Given these circum- i¼1
stances we make a further assumption: qi P 0; 8 i 2 f1; . . . ; mg: ð23Þ

A4: The financial institution charges the DM a premium of pro- The objective function (20) less the constant l0 represents the
portion of investment u and agrees to pay the DM propor- expected net return collected by the financial institution. Con-
tion of investment sj should state of nature j occur. straints (21) are for ensuring that the risk threshold is not violated
under any state of nature. Constraint (22) is for normalizing the
The financial institution determines its acceptable risk thresh- portfolio.
old, T, and then may solve the following LP model to construct a It is a simple matter to remove the nonlinearity in (20) by
portfolio: employing nonnegative variables c+ and c in an additional
constraint:
LPðFIÞ Max zFI ¼ E½q; ð15Þ
X
m
Xm
cþ  c ¼ qi E½ri   l0 : ð24Þ
s:t: qi rij þ u  sj P T; 8 j 2 f1; . . . ; ng; ð16Þ i¼1
i¼1
X
m This yields the LP model:
qi 6 1; ð17Þ
i¼1
X
m
LPðAÞ Max qi E½ri   l1 cþ : ð25Þ
qi P 0; 8 i 2 f1; . . . ; mg: ð18Þ i¼1

Maximizing the expected return (15) is the objective function.
The constraints (16) are for ensuring that the total return plus
the premium less the supplement paid out to the DM does not vio-
late the institution’s risk level T under any state of nature, and (17)
is for normalizing the institutional portfolio.
Of interest to both parties is the minimal premium that would
permit the institution to provide the insurance. This can be found
by replacing zFI with u, the premium, and solving:
LPðPÞ Min u;
subject to (16)–(18), and u P 0. The optimal objective value of this
LP, u*, is the smallest premium that guarantees the financial institu-
tion a return of at least T for every state of nature. This provides a
benchmark for the institution’s negotiations with the DM in regard
to the premium.
6. Design of annuities
A DM might not desire or be able to diversify investments as
prescribed by the optimal solution to LP(M) or LP(DM) for several
reasons. Some investments may have minimum purchase require-
ments or may only be available in multiples of discrete fixed
amounts. A DM may find it unacceptable if LP(DM) results in an
subject to (21)–(23). An optimal solution to LP(A) identifies a port-
folio that maximizes the net expected return for the financial insti-
tution for given values of l0 and l1. For a specified risk threshold, T,
the institution could identify attractive annuities for consumers by
testing the market for various values of the parameters l0 and l1.
Ultimately the institution could choose a set of annuity offerings
that its clients find appealing and provides the institution an
acceptable expected return for the capital it is willing to risk.
ð19Þ
7. Applications
Detailed results for a small example and summary results for a
larger example will demonstrate the applicability of our models to
realistic investment decision-making situations. In Table 1 is
Example 1 with annual returns for six mutual funds, the decision
alternatives. The states of nature are five potential economic sce-
narios for the coming year along with subjectively determined
prior probabilities. The minimum return and expected return for
each decision alternative are shown. Similar data is presented in
Table 2 for 79 mutual funds and 10 potential economic scenarios
comprising Example 2. Microsoft Excel Solver was used to find
optimal solutions for all instances of the models. Optimal portfo-
lios for LP(DM) with T = 0.05 are in Fig. 1 for both examples. The
414 G.G. Polak et al. / European Journal of Operational Research 207 (2010) 409–419

Table 1
Example 1: returns (rij) for six investment alternatives. Each year corresponds to a state of nature and is given a prior probability.

Decision alternative States of nature and prior probabilities Min EV

Year 1 Year 2 Year 3 Year 4 Year 5
0.48 0.26 0.23 0.02 0.01
Foreign Stock (FS) 0.3694 0.1006 0.0579 0.4542 0.2193 0.2193 0.2237
Large-Cap Growth (LCG) 0.1058 0.3241 0.2519 0.4146 0.2326 0.2326 .1990
Large-Cap Value (LCV) 0.1391 0.3236 0.2689 0.0706 0.0537 0.0537 .2136
Long-Term Bond (LTB) 0.1348 0.2117 0.1053 0.0302 0.0751 0.0302 .1441
Short-Term Bond (STB) 0.0702 0.1134 0.0661 0.0229 0.0732 0.0229 .0796
Small-Cap Growth (SCG) 0.1593 0.3344 0.1898 0.5868 0.0902 0.0902 .2179

Table 2
Example 2: returns for 79 investment alternatives. Each year corresponds to a state of nature and is given a prior probability.

Decision alternative States of nature and prior probabilities Min EV

2006 2005 2004 2003 2002 2001 2000 1999 1998 1997
0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1
500 Index Fund Inv. 0.1564 0.0477 0.1074 0.285 0.2215 0.1202 0.0906 0.2107 0.2862 0.3319 0.2215 0.0993
Admiral Trsy Money Mkt 0.0471 0.0294 0.0118 0.0099 0.0169 0.0416 0.0599 0.0474 0.0518 0.0529 0.0099 0.03687
Asset Allocation Fund Inv. 0.1602 0.05 0.1109 0.2642 0.1538 0.0534 0.0495 0.0521 0.254 0.2732 0.1538 0.10069
Balanced Index Fund Inv. 0.1102 0.0465 0.0933 0.1987 0.0952 0.0302 0.0204 0.1361 0.1785 0.2224 0.0952 0.08399
CA IT Tax-Exempt Investor 0.0426 0.0186 0.0289 0.0412 0.0916 0.0443 0.1094 0.0058 0.0606 0.0767 0.0058 0.05081
CA LT Tax-Exempt Investor 0.0524 0.0378 0.0419 0.0492 0.0944 0.0336 0.1518 0.031 0.0663 0.0892 0.031 0.05856
CA Tax-Exempt Money Mkt 0.0329 0.0229 0.0111 0.0089 0.013 0.0238 0.0346 0.0282 0.0305 0.0341 0.0089 0.024
Capital Opportunity Inv. 0.1678 0.0827 0.2165 0.4955 0.2794 0.0968 0.1804 0.9777 0.3198 0.0793 0.2794 0.19849
Convertible Securities 0.1294 0.066 0.072 0.3158 0.0935 0.0309 0.0421 0.3036 0.0056 0.1639 0.0935 0.0974
Dividend Growth Fund 0.1958 0.0423 0.1102 0.292 0.2316 0.1945 0.1877 0.0296 0.2183 0.2509 0.2316 0.08415
Emerging Mkts Stk Idx. Inv. 0.2939 0.3205 0.2612 0.5765 0.0743 0.0288 0.2756 0.6157 0.1812 0.1682 0.2756 0.13397
Energy Fund Investor 0.1966 0.446 0.3665 0.338 0.0062 0.0255 0.3643 0.2098 0.2053 0.1489 0.2053 0.18331
Equity Income Fund Inv. 0.2062 0.0437 0.1357 0.2514 0.1565 0.0234 0.1357 0.0019 0.1734 0.3117 0.1565 0.1076
European Stock Index Inv. 0.3342 0.0926 0.2086 0.387 0.1795 0.203 0.0818 0.1662 0.2886 0.2423 0.203 0.12552
Explorer Fund Investor 0.097 0.0928 0.1375 0.4425 0.2458 0.0056 0.0922 0.3726 0.0352 0.1457 0.2458 0.11753
Extended Mkt Index Inv. 0.1427 0.1029 0.1871 0.4343 0.1806 0.0913 0.1555 0.3622 0.0832 0.2673 0.1806 0.11523
Federal Money Mkt Fund 0.0481 0.0296 0.0108 0.0089 0.0164 0.0422 0.0619 0.0494 0.0531 0.0538 0.0089 0.03742
FL LT Tax-Exempt Investor 0.045 0.0259 0.0408 0.0567 0.1084 0.0455 0.1322 0.0276 0.0669 0.0894 0.0276 0.05832
Global Equity Fund 0.2359 0.1177 0.2009 0.4451 0.0561 0.0373 0.0017 0.2595 0.0939 0.0691 0.0561 0.1327
GNMA Fund Investor Shares 0.0433 0.0333 0.0413 0.0249 0.0968 0.0794 0.1122 0.0078 0.0714 0.0947 0.0078 0.06051
Growth and Income Inv. 0.1401 0.0582 0.1111 0.3015 0.2192 0.1113 0.0897 0.2604 0.2394 0.3559 0.2192 0.10464
Growth Equity Fund 0.0614 0.0788 0.0535 0.3856 0.3094 0.2741 0.231 0.536 0.3807 0.3136 0.3094 0.09951
Growth Index Fund Inv. 0.0901 0.0509 0.072 0.2592 0.2368 0.1293 0.2221 0.2876 0.4221 0.3634 0.2368 0.09571
Health Care Fund Inv. 0.1087 0.1541 0.0951 0.2658 0.1136 0.0687 0.6053 0.0705 0.408 0.2857 0.1136 0.18109
High-Yield Corp. Fund Inv. 0.0824 0.0277 0.0852 0.172 0.0173 0.029 0.0088 0.0255 0.0562 0.1191 0.0088 0.06056
High-Yield Tax-Exempt Inv. 0.0553 0.0434 0.0498 0.0635 0.073 0.0534 0.1073 0.0338 0.0645 0.0924 0.0338 0.05688
Ins LT Tax-Exempt Inv. 0.0492 0.0337 0.0393 0.0577 0.1003 0.043 0.1361 0.0291 0.0613 0.0865 0.0291 0.0578
Inter-Term Bond Index Inv. 0.0391 0.0175 0.0522 0.0565 0.1085 0.0928 0.1278 0.03 0.1009 0.0941 0.03 0.06594
Inter-Term Invest-Gr. Inv. 0.0443 0.0197 0.0475 0.0629 0.1028 0.0942 0.107 0.0153 0.083 0.0893 0.0153 0.06354
Inter-Term Tax-Exempt Inv. 0.0443 0.0224 0.0323 0.0446 0.0791 0.0505 0.0924 0.005 0.0576 0.0708 0.005 0.0489
Inter-Term Treasury Inv. 0.0314 0.0232 0.034 0.0237 0.1415 0.0755 0.1403 0.0352 0.1061 0.0896 0.0352 0.06301
Internatl Explorer Fund 0.3034 0.2049 0.3177 0.5737 0.1388 0.2252 0.0268 0.9029 0.2598 0.1413 0.2252 0.20303
International Growth Inv. 0.2592 0.15 0.1895 0.3445 0.1779 0.1892 0.086 0.2634 0.1693 0.0412 0.1892 0.0964
International Value Fund 0.2737 0.1796 0.1977 0.419 0.1335 0.1402 0.0748 0.2181 0.1946 0.0458 0.1402 0.10884
LifeStrategy Consrv Grwth 0.1062 0.0445 0.0802 0.1657 0.0537 0.0008 0.0312 0.0786 0.1588 0.1681 0.0537 0.07788
LifeStrategy Growth Fund 0.1613 0.0688 0.1258 0.2852 0.1584 0.0886 0.0544 0.1732 0.214 0.2226 0.1584 0.09495
LifeStrategy Income Fund 0.0793 0.0323 0.0601 0.1077 0.0012 0.0406 0.0806 0.0282 0.1317 0.1423 0.0012 0.0704
LifeStrategy Mod Growth 0.1331 0.0569 0.1057 0.224 0.1032 0.0448 0.0088 0.1201 0.1903 0.1977 0.1032 0.0871
Ltd-Term Tax-Exempt Inv. 0.0333 0.0111 0.0153 0.0279 0.0631 0.0558 0.0635 0.0147 0.0512 0.051 0.0111 0.03869
Long-Term Bond Index 0.0267 0.0532 0.084 0.055 0.1435 0.0817 0.1664 0.0785 0.1198 0.143 0.0785 0.07948
Long-Term Invest-Gr. Inv. 0.0286 0.0513 0.0894 0.0626 0.1322 0.0957 0.1176 0.0623 0.0921 0.1379 0.0623 0.07451
Long-Term Tax-Exempt Inv. 0.0516 0.0307 0.0412 0.0521 0.1011 0.0454 0.1332 0.0353 0.0602 0.0929 0.0353 0.05731
Long-Term Treasury Inv. 0.0174 0.0661 0.0712 0.0268 0.1667 0.0431 0.1972 0.0866 0.1305 0.139 0.0866 0.07714
Morgan Growth Fund Inv. 0.1109 0.0909 0.1047 0.3373 0.2352 0.136 0.1251 0.341 0.2226 0.3081 0.2352 0.10192
NJ LT Tax-Exempt Investor 0.0524 0.0285 0.0398 0.0517 0.0992 0.0458 0.1248 0.0235 0.0632 0.0857 0.0235 0.05676
NJ Tax-Exempt Money Mkt 0.0331 0.0229 0.0108 0.0086 0.0125 0.0259 0.0372 0.029 0.0313 0.0333 0.0086 0.02446
NY LT Tax-Exempt Investor 0.0484 0.0282 0.0396 0.0535 0.1076 0.0413 0.1376 0.0335 0.0627 0.0874 0.0335 0.05728
OH LT Tax-Exempt Fund 0.0485 0.0264 0.041 0.0533 0.1071 0.0464 0.129 0.03 0.0625 0.0848 0.03 0.0569
OH Tax-Exempt Money Mkt 0.0336 0.0233 0.0112 0.0093 0.0138 0.0279 0.04 0.0309 0.0332 0.035 0.0093 0.02582
Pacific Stock Index Inv. 0.1199 0.2259 0.1883 0.3842 0.0932 0.2634 0.2574 0.5705 0.0241 0.2567 0.2634 0.06422
PA LT Tax-Exempt Investor 0.0481 0.0271 0.0389 0.056 0.1008 0.0476 0.1277 0.0266 0.0619 0.0825 0.0266 0.0564
PA Tax-Exempt Money Mkt 0.0337 0.0232 0.011 0.0089 0.0129 0.0266 0.0395 0.031 0.0329 0.035 0.0089 0.02547
Precious Metals & Mining 0.343 0.4379 0.0809 0.5945 0.3335 0.1833 0.0734 0.2882 0.0391 0.3892 0.3892 0.17596
Prime Money Mkt Fund 0.0488 0.0301 0.0111 0.009 0.0165 0.0417 0.0629 0.0501 0.0538 0.0544 0.009 0.03784
PRIMECAP Fund Investor 0.1232 0.0849 0.1831 0.3775 0.2456 0.1335 0.0447 0.4134 0.2544 0.3679 0.2456 0.147
REIT Index Fund Inv. 0.3507 0.1189 0.3076 0.3565 0.0375 0.1235 0.2635 0.0404 0.1632 0.1877 0.1632 0.15423
 G.G. Polak et al. / European Journal of Operational Research 207 (2010) 409–419 415

Table 2 (continued)

Decision alternative States of nature and prior probabilities Min EV

2006 2005 2004 2003 2002 2001 2000 1999 1998 1997
0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1
Selected Value Fund 0.1911 0.1067 0.2038 0.3521 0.0979 0.1499 0.1745 0.0272 0.1177 0.174 0.1177 0.11093
Short-Term Bond Index Inv. 0.0409 0.0131 0.017 0.0337 0.061 0.0888 0.0884 0.0208 0.0763 0.0704 0.0131 0.05104
Short-Term Federal Inv. 0.0432 0.018 0.0136 0.0199 0.0761 0.0861 0.0918 0.0207 0.0722 0.0646 0.0136 0.05062
Short-Term Invest-Gr. Inv. 0.0499 0.022 0.0211 0.042 0.0522 0.0814 0.0817 0.033 0.0657 0.0695 0.0211 0.05185
Short-Term Tax-Exempt Inv. 0.0326 0.0165 0.0112 0.0164 0.0349 0.0475 0.0491 0.0258 0.0432 0.0407 0.0112 0.03179
Short-Term Treasury Inv. 0.0377 0.0177 0.0103 0.0238 0.0802 0.078 0.0883 0.0185 0.0736 0.0639 0.0103 0.0492
Small-Cap Index Fund Inv. 0.1564 0.0736 0.199 0.4563 0.2002 0.031 0.0267 0.2313 0.0261 0.2459 0.2002 0.11405
STAR Fund 0.1164 0.0744 0.116 0.227 0.0987 0.005 0.1096 0.0713 0.1238 0.2115 0.0987 0.09563
Strategic Equity Fund 0.1343 0.0997 0.2049 0.4383 0.1314 0.0542 0.0746 0.1925 0.0061 0.2622 0.1314 0.13354
Tax-Exempt Money Mkt 0.0337 0.0235 0.0114 0.0094 0.014 0.0272 0.0401 0.0316 0.0334 0.0354 0.0094 0.02597
Tax-Managed Balanced Fund 0.0909 0.048 0.0716 0.1705 0.0707 0.0354 0.005 0.1549 0.1693 0.1655 0.0707 0.07596
Tax-Managd Cap Apprec Inv. 0.144 0.0749 0.1175 0.3172 0.2345 0.1534 0.1013 0.335 0.2795 0.2729 0.2345 0.10518
Tax-Managed Gr. & Inc. Inv. 0.1573 0.0487 0.1083 0.2853 0.2195 0.1193 0.0903 0.2112 0.2867 0.3331 0.2195 0.10015
Total Bond Mkt Index Inv. 0.0427 0.024 0.0424 0.0397 0.0826 0.0843 0.1139 0.0076 0.0858 0.0944 0.0076 0.06022
Total Int’l Stock Index 0.2664 0.1557 0.2084 0.4034 0.1508 0.2015 0.1561 0.2992 0.156 0.0077 0.2015 0.0973
Total Stock Mkt Idx. Inv. 0.1551 0.0598 0.1252 0.3135 0.2096 0.1097 0.1057 0.2381 0.2326 0.3099 0.2096 0.10092
Treasury Money Mkt Fund 0.0455 0.0277 0.01 0.0082 0.0151 0.0399 0.058 0.0455 0.05 0.0512 0.0082 0.03511
US Growth Fund Investor 0.0177 0.1115 0.0703 0.261 0.358 0.317 0.2017 0.2228 0.3998 0.2593 0.358 0.04657
Value Index Fund Inv. 0.2215 0.0709 0.1529 0.3225 0.2091 0.1188 0.0608 0.1257 0.1464 0.2977 0.2091 0.10705
Wellesley Income Fund Inv. 0.1128 0.0348 0.0757 0.0966 0.0464 0.0739 0.1617 0.0414 0.1184 0.2019 0.0414 0.08808
Wellington Fund Inv. 0.1497 0.0682 0.1117 0.2075 0.069 0.0419 0.104 0.0441 0.1206 0.2323 0.069 0.1011
Windsor Fund Investor 0.1935 0.0499 0.1338 0.3701 0.2225 0.0572 0.1589 0.1157 0.0081 0.2197 0.2225 0.10844
Windsor II Fund Inv. 0.1825 0.0701 0.1831 0.3008 0.1686 0.034 0.1686 0.0581 0.1636 0.3237 0.1686 0.11317

Example 2 solution includes only four of the 79 investment alter-
natives which is a manageable number for most DM’s.
7.1. The DM and financial services
Post-optimality analysis may indicate an opportunity for a
financial services firm to partner with the DM for mutual benefit
resulting in an overall larger return. Such a firm usually has more
resources to tolerate large losses and thus assume more risk than
a typical DM. Thus a firm could adjust a DM’s portfolio to obtain
a higher expected return at a higher level of risk while insuring
the DM’s chosen risk threshold by supplementing the return if it
falls below T0. Suppose we wish to analyze a change in T to 0.03
so that DT = 0.02 in Example 1. Optimal dual prices are a4 ¼
0:032; a5 ¼ 0:564, and aj ¼ 0 for all other states and the allow-
able decrease in the right-hand-sides for constraints (6) are
d  
4 ¼ 0:06056; d5 ¼ 0:07378, and dj ¼ 1 for all other states. By
Pn jDTj 0:02 0:02
the 100% rule, (Bradley et al., 1977) j¼1 d ¼ 0:06056 þ 0:07738 ¼
j

0:588 < 1, and thus the current basis of Large-Cap Value,

Optimal Portfolio for Example 1, T =0.05 Long-Term Bonds, and Small-Cap Growth remains optimal for
Large-Cap LP(DM). The change in the optimal objective value is DzDM ¼
Value ð0:032Þð0:02Þ þ ð0:564Þð0:02Þ ¼ 0:01192 and the updated
Small-Cap 4% portfolio will include 28.5% invested in Large-Cap Value, 66.4% in
Growth Long-Term Bonds, and 5.1% in Small-Cap Growth. This new solu-
12% tion involves more risk but correspondingly allows for more poten-
tial return and the DM can select the preferred scenario.
The financial services firm would be liable for any shortfall of
return from the updated portfolio with regard to the DM’s risk
Long-Term threshold. For this updated portfolio the shortfall of return with re-
Bond  P
spect to the initial T = 0.05 is Maxj 0; T  m i¼1 qi r ij ¼
0

84% 0:02; for j ¼ 4; 5

and the expected shortfall is (0.02)(0.02) +
0; otherwise
Optimal Portfolio for Example 2, T =0.05 (0.01)(0.02) = 0.0006. The firm would compare this expected short-
fall to the increase in expected return of 0.01192 in order to make a
REIT Index Energy Fund decision on whether to partner with the DM by managing the port-
folio, assuming an additional risk of 0.02, and insuring the risk
Fund Inv Investor
threshold of T = 0.05.
20.7% 18.6% Let b denote the corresponding dual variable for (7), the nor-
malization constraint on the amount to invest. Its optimal value,
b*, is the marginal rate of change in expected return with respect
to changing the size of the entire investment in the portfolio, all
Precious Health Care else unchanged, and is valid for changes in the right-hand-side of
Metals & Fund Inv (7) within sensitivity limits. The firm can make a decision on
Mining 32.6% advancing funds based on a comparison of the cost of capital to
28.2% b*. For Example 1, b* = 0.1855 with T = 0.05 and 2.12 is the allow-
able increase in the right-hand-side of (7). By increasing the
Fig. 1. Optimal portfolios from LP(DM) for Examples 1 and 2. right-hand-side of (7) by, e.g., 0.50, an increase in the optimal
416 G.G. Polak et al. / European Journal of Operational Research 207 (2010) 409–419

Prior and Surrogate Prior Distributions for Example 1, T =0.05 expected return of (0.1855)(0.5) = 0.09275 would result. If the cost
of borrowing the funds to make a 50% increase is less than 0.09275,
0.6
a financial services firm would have an opportunity for partnering
Prior Distribution with a DM by advancing the DM funds for investment. Surrogate
0.5
Surrogate Prior Distribution prior distributions for both examples are in Fig. 2. The surrogate
0.4 prior distribution, a measure of the difference between the EV rule
probability

and LP(DM), is obtained from minimizing kkk1 subject to (10), (11)

0.3 and (14) and yields an alternative probability distribution for
which q* also maximizes EV. For Example 1, the upper bound from
0.2 Corollary 2 is 2Maxj ½1  ppj  ¼ 2ð0:99Þ ¼ 1:98, the optimal objec-
tive value is kk*k1 = 0.5127, and thus the relative divergence from
0.1
the EV rule is kk k1 =2 max½1  pj  ¼ 0:2589. In Example 2,
j
0 2Maxj ½1 ppj  ¼ 2ð0:9Þ ¼ 1:8; kk k1 ¼ 0:145, and kk k1 =2 max½1
j
1 2 3 4 5 pj  ¼ :0806.
state

Prior and Surrogate Prior Distributions for Example 2, T =0.05 7.2. The risk vs. return tradeoff curve

0.2 Risk vs. return tradeoff curves are in Fig. 3. For Example 1, the
0.18 Prior Distribution breakpoints coincide with changes in the optimal basic solutions
0.16 Surrogate Prior Distribution as T is varied. On the leftmost segment of the curve, i.e., for
0.14 T 6 minfr i ;j g ¼ 0:2193, the expected return is constant at 0.2237,
j
probability

0.12 which is the maximum EV in Table 1 and is uniquely associated

0.1 with Foreign Stocks. The optimal objective value for LP(M) is
0.08 0.0619 at the rightmost point, and thus for T > T2 = 0.0619,
0.06
LP(DM) is infeasible. Observe that of the 26  1 = 63 possible non-
empty subsets of the six funds, only nine need be considered to
0.04
capture optimality for all choices of the DM’s risk threshold T.
0.02
For Example 2, the curve was derived by solving LP(DM) at regular
0
intervals of length 0.003 for values of T ¼ minj fri ;j g ¼ 0:225 to
1 2 3 4 5 6 7 8 9 10
state T ¼ zM ¼ 0:085 and by Theorem 1 LP(DM) is infeasible for
T > 0.085. The average number of investment alternatives in the
Fig. 2. Prior and surrogate prior distributions for Examples 1 and 2. optimal portfolios for these values of T is 3.72 with a maximum
of six.

Risk vs. Return Trade-off Curve

LCV, LTB
SCG LCV
Optimal Expected Return

0.25

0.2
FS
SCG,LCV
0.15
FS, SCG
LCV, LTB, SCG 0.1

0.05
STB, LTB, SCG STB, SCG
0
-0.3 -0.25 -0.2 -0.15 -0.1 -0.05 0 0.05 0.1
Risk Threshold T

Risk vs. Return Trade-off Curve

Optimal Expected Return

Risk Threshold T

Fig. 3. Risk vs. return tradeoff curves for LP(DM) for Example 1 (top) and Example 2 (bottom). Optimal bases are indicated for Example 1.
 G.G. Polak et al. / European Journal of Operational Research 207 (2010) 409–419 417

The piecewise linear curves in Fig. 3 are the efficient frontiers of
minimax risk and expected returns. Only a portfolio represented by
an optimal basic feasible solution on the efficient frontier need be
considered. Each line segment on the curve in Fig. 3 corresponds to
a class of investors who share a common set of decision alterna-
tives comprising a portfolio. In this way a financial services firm
can use parametric analysis to segment the market of potential
investor clients.
threshold T = 0.05. The institutional portfolio in this case calls for
97.21% in the Short-Term Bond Fund and 2.79% in the Small-Cap
Growth Fund. Solving LP(P) for Example 2, the minimal premium
is 0.0652 for an institutional portfolio consisting of 7.07% in the
Capital Opportunity Fund, 60.49% in the Long-Term Investment
Grade Fund, 11.20% in the Precious Metals and Mining Fund,
12.75% in the Strategic Equity Fund, and 8.48% in the Wellesley
Income Fund.

7.3. Investment insurance

Suppose that the DM turns to a financial institution for insur-
ance in Example 1 as described in Section 5. We suppose an array
of supplements s = [0.05, 0.04, 0.06, 0.05, 0.08] is required for the
scenarios corresponding to 1993 through 2001, respectively. We
also suppose that the institution is willing to accept a risk thresh-
old of T = 0.05 while requiring a premium u = 0.07. Solving LP(FI)
to optimality with these parameters, the insurer’s funds should
be placed as follows: 82.62% in the Long-Term Bond Fund, 8.34%
in the Short-Term Bond Fund, and 9.04% in the Small-Cap Growth
Fund. This institutional portfolio would maximize the insurer’s
gross portfolio return at 0.1454, from which we subtract the ex-
pected value of insurance payments to the DM of E[s] = 0.05 to
get an expected net return of 0.0954. We can add 0.07 to that for
the insurance premium to obtain a return of 0.1654 to the insur-
ance company on the funds invested. With identical choices of T
and u in Example 2, and all sj = 0.10, an optimal solution to LP
(FI) gives an optimal gross return of 0.1311 for the insurer from
a portfolio consisting of 14.5% in the Health Care Fund, 27.72% in
the Long-Term Bond Fund, 8.27% in the Long-Term Investment
Grade Fund, 20.93% in the Precious Metals and Mining Fund, 8.0%
in the REIT Index Fund, and 20.58% in the Strategic Equity Fund.
The expected net return to the insurer is therefore 0.1311 + 0.07 
0.10 = 0.1011.
Finally, if we solve LP(P) for Example 1, the minimal premium
u* is 0.0614. This is the smallest proportion of investment the in-
surer could require from the DM while not violating the risk
Design of Annuities, Example 1
0.2000
Net Return
0.1500
to
0.1000
Institution 0.0500
0.000
0.004
0.008 Fixed
0
7.4. An illustration of optimal annuity design
Suppose a financial institution wants to design an annuity of the
type proposed in Section 6. Contours for the net expected returns
to the insurer for joint choices of fixed (l0) and variable (l1) pay-
out proportions are in Fig. 4 for both examples with T = 0.05. For
Example 1 with l0 = 0.0059 and l1 = 0.2 an optimal solution to
LP(A) would give the insurer a net return, after payouts to annuity
holders, of 0.101. by investing 57.37% in the Long-Term Bond Fund,
31.37% in the Short-Term Bond Fund, and 11.25% in the Small-Cap
Growth Fund. For Example 2 with an identical choice of parame-
ters, an optimal solution to LP(A) would give the insurer a net re-
turn of 0.13375 by investing 13.43% in the Energy Fund, 33.35% in
the Health Care Fund, 27.61% in Precious Metals and Mining, and
25.61% in the REIT Index Fund.
8. Conclusions and future research directions
Protecting the DM against risk is the primary objective with
minimax modeling for portfolio optimization. We provided and ex-
tended LP models that permit the DM to diversify when decision
alternatives are divisible and developed theory to assist a DM or
financial institution in the area of risk/return tradeoffs. A manage-
able number of investment alternatives were sufficient for opti-
mality in all problem instances for a real-world application. From
the popular press, Jaffe (2008) indicates that no more than six
funds are needed to build a winning portfolio and our results indi-
cate that LP(DM) provides portfolio recommendations that are
consistent with this rule of thumb.
A straightforward measure of downside risk for returns – a risk
threshold, T – and optimal diversification of funds characterizes
each of our optimization models. In the case of the diversified port-
folio for a DM, LP(DM), we showed that there is a relevant range
for choices of T for which the optimal balance between risk and re-
turn varies. Higher values of T correspond to less downside risk and
are more appropriate for the conservative DM. Lower values of T

0.012
0.4

Payout
0.8

correspond to less risk but greater return and are more suitable
for an aggressive DM. A degree of Knightian, or model, uncertainty
Variable Payout
that corresponds to the choice of risk threshold was quantified as a
measure of the difference between the EV rule and LP(DM) with a
Design of Annuities, Example 2 specified T using Lagrangian relaxation. The surrogate prior proba-
bility distribution subsequently developed sheds light on a DM’s
0.2000 risk attitude and decision behavior. The LP models derived are ver-
0.1500 satile and can be adapted to cases in which diversification is
Net Return
deemed unwieldy or for optimizing portfolio insurance and design-
to 0.1000
ing a variable annuity with a guaranteed fixed return, plus a spec-
Institution 0.0500 ified proportion of any returns over this fixed amount.
0.000 Opportunities for further research include extending the mod-
0.010
0.020 els with probabilistic modeling approaches. For example, stochas-
Fixed
0.030 tic programming with recourse can be employed to model
0

Payout
0.3
0.6

multiple-stage investment decisions such as Edirisinghe and Patt-

0.9

Variable Payout erson (2007) who exploit a block separable recourse structure to
overcome the dimensionality of problems with many securities.
Fig. 4. Expected net return to insurer for choices of fixed (l0) and variable (l1) Likewise, a chance-constrained programming approach for the risk
payout proportions with T = 0.05 for Examples 1 and 2. threshold constraint could be incorporated.
418 G.G. Polak et al. / European Journal of Operational Research 207 (2010) 409–419

Appendix A. Proofs of theorems and corollaries Consider state of nature q ¼ arg minfr^ij g and let k be given by
kq ¼ 1  ppq ; kj ¼ ppj 8 j – q; j 2 f1; .j . . ; ng which satisfies (11)
Pn Pn p
and
Pn
also (10)
Pn p
since j¼1 kj ¼ kq þ j¼1;j–q kj ¼ 1  pq þ
j
Proof of Theorem 1 j¼1;j–q ðpp Þ ¼ 1  j¼1 pj ¼ 0. Substituting into (30) gives

X
m
(i) Increasing T makes the constraints (6) more restrictive. So, r^iq > qk rkq : ð31Þ
zDM cannot increase if T is increased. k¼1

(ii) If T 6 min fri ;j g, then all constraints (6) become redundant. Pm  *

j However, k¼1 qk r kq P T by (6) because q is feasible for
Since at least one E[ri] > 0, increasing qi as much as possible LP(DM) and thus r^iq > T which is a contradiction to the bound in
is feasible and thus qi ¼ 1 is optimal.  
(ii) because minfr^ij g 6 max minj fr ij g 6 T. Therefore the assertion
(iii) The solution to LP(M) reveals the largest possible value for j
of the corollary must hold. 
i
Pm
i¼1 r ij vi over all j. With T ¼ zM , (2) and (6) are identical


except for the difference in variable notation. But, if

T > zM , then constraints (6) cannot be satisfied since no lar- Proof of Corollary 2. We can write kj as a difference of a positive
Pm
ger value for i¼1 r ij qi exists and thus LP(DM) is and a negative part:
infeasible.  kj = uj  vj where uj P 0, vj P 0, and uj  vj = 0, " j 2 {1, . . ., n}.
Moreover (11) implies uj 6 1  pj and vj 6 pj, " j 2 {1, . . ., n}. By (10)
Pn Pn Pn
j¼1 kj ¼ j¼1 uj  j¼1 v j ¼ 0 so

Proof of Theorem 2. If (13) holds for every q satisfying (7) and (8), X
n X
n

it must hold for q set equal to each unit vector e1 = (1, 0, . . ., 0), uj ¼ vj: ð32Þ
j¼1 j¼1
e2 = (0, 1, 0, . . ., 0), . . ., em = (0, . . ., 0, 1) so that substituting ei into
(13) and using the simplification from (12) yields: If kj = 0, " j 2 {1, . . ., n}, then the assertion of the corollary holds
trivially. Otherwise, uj > 0 for at least one j 2 {1, . . ., n}; w.l.o.g.,
n 
X  X
n X
m   Pn Pn Pn
ppj þ kj rij 6 q~ k ppj þ kj rkj ; 8 i 2 f1; . . . ; mg: ð26Þ assume u1 > 0 so that v1 = 0. Thus j¼1 v j ¼ j¼2 v j 6 j¼2 pj ¼

j¼1 j¼1 k¼1 1  p1 6 maxj ½1  pj . Since jkjj = uj + vj, " j 2 {1, . . ., n} and with
Pn Pm p (32)
k¼1 pj qk ðr kj 
Rearranging terms and recognizing that j¼1
~
rij Þ ¼ E½q
~   E½r i  yields (14). X
n X
n X
n X
n
jkj j ¼ uj þ vj ¼ 2 v j 6 2 max½1  pj :  ð33Þ
Conversely, given (14), a rearrangement of terms yields (26). j¼1 j¼1 j¼1 j¼1
j

Consider any portfolio q satisfying (7) and (8), which must be a

P
convex combination of the ei, i.e., q ¼ m i¼1 qi ei . Employing (26) we
get: References

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