A Study on Investment Decision Making Model:

Genetic Algorithms Approach

Wen-Shiu Lin* Jiah-Shing Chen** Ping-Chen Lin***
Department of Information Management
National Central University
Chung-Li , Taiwan 32054, R.O.C.

* wslin@im.mgt.ncu.edu.tw

** jschen@im.mgt.ncu.edu.tw

*** lisaf&al.im.vit.edu.tw
Abstract
Genetic algorithms (GAS) are becoming a new paramount
research method because of its robustness from mimicking
the natural evolution mechanism. Genetic algorithms can
easily learn to adapt to complex environments . This paper
studies the application of genetic algorithms on user-
oriented “investment decision-making model”. The portfolio
selection considers userlts pderences i n addti on to the
common return and risk factors. Preliminary results show
that the portfolios generated by GAS outperform some of the
better mutual funds and the index.
Keywords: Genetic algorithms, Investment decision making
model, User-oriented.
1. Introduction
Conventional investment decision making model
relies mostly on mathematic model. They only include
quantifiable objective variables into a model. Many
problems are therefore simplified and distorted. Investors,
however, face somewhat complicated solution spaces. When
it comes to decision making, they are likely to carry it on
according to their subjective experiences, personal
preferences, and mentality. In a complex, noisy, or stressful
environment, when a decision maker makes a policy
according to simple subjective rules, he might make
numerous mistakes in his decision unconsciously (Tversky
and Kahneman, 1983; Bernstein, 1998). Therefore, it is not
an easy job for an investor to seek a profitable investment
strategy to go on his investment either by an objective
investment decision making model or by his subjective
personal preference.
When we judge the probability of events, we are
affected by investor’s individuality, mentality, mental limits,
and decision styles, etc. In the activity of portfolio selection,
they are apt to be affected by these factors so numerous
errors and limits occur. Modem portfolio theory was
initiated and developed by Markowitz in 1952. Afterwards,
Sharpe and other scholars brought up many revised theories.
However, these methods are mostly linear and time-
consuming. It is very important for general investors to have
a user-oriented and profitable investment decision making
model in a complex environment.
From the above-mentioned fact, we found that this is
room for improvement in the investment decision of
financial market. The genetic algorithms (GAS) are able
make a speedy search for good solutions in a large solution
space by evolution. In addition, GAlts robti ness and
domain independence make it a suitable tool for diverse
domains.
This research applies GAS on user-oriented investment
decision making model which considers userlts peferences
in addition to the common return and risk factors.
Preliminary results show that the portfolio generated by GAS
outperform some of the better mutual funds and index
during and test period.
The content structure of this paper is as follows:
Section 2 investment decision- making theory; Section 3
Genetic Algorithms Approach, Section 4 brings up “research
model and Methodology”, Section 5: Experiment Result and
Discussion, and the final section: Conclusion and continuous
research direction.
2. Investment decision theory
2.1 Portfolio decision model
Portfolio is a collection of more than one stocks,
bonds or assets. Investors select a optimal portfolio among
various possible portfolios. Therefore, the conventional
portfolio theory focuses on minimizing risks and
maximizing, weighing between risks and investment
performance.
Conventional portfolio theory is originated from
Markowitz, who quantified risk and put forth” mean-
variance criterion ” to select a optimal portfolio, meaning in
a fixed risk, enable the rate of return to the maximum, or in
a fixed rate of return, reduce the risk to the minimum
(Markowitz, 1952). Due to a large amount of calculations,
time and cost required for this mode, and the performance of
trial time is not good enough, so this mode is not broadly
accepted by the market. And differential can use Lagrangian
objective function to obtain weights of portfolio. However,
the shortcoming is that differential is unable to handle the
limitation of an inequality. Another method is quadratic
programming method, whose needed information is
somewhat like differential and it can solve the effective and
quantifiable question. Yet, When the quadratic programming
method seeks an efficient portfolio, there are so many

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parameters that the value becomes impractical (for example,
the wi limit can not less than zero, so it cannot cover the
status of short sales).
Therefore, in light of this concept, Sharpe developed
a single index model, meaning. the simplification of
0; portfolio variance of the above quadratic programming
method and determination of weights of efficient portfolio.
The basic hypothesis of a single index model is that
interrelations of returns of stocks and bonds can be
interpreted by random factors( fi ), and market factors(k).
The application of a single index model, however, has its
shortcoming. For example, a single index is apt to neglect
the significant relations among stocks and bonds; the
different index will bring out different efficient frontier, and
an inappropriate selection will be likely to bring about
misunderstanding.
The limitation of applying the above analysis of the
conventional portfolio can be induced as follows: 1. Only
linear portfolio can be solved. 2. Computing procedures or
parameters are too complicated. 3. The influence variables
of portfolio can not flexibly used. Nevertheless, the nature
of financial market has characteristic of Chaos system of
time series, nonlinear plus nonpredictable in long time scale,
which can not be achieved by the conventional analysis
method. Consequently, this research bring up the genetic
algorithms(GAs) as a selection tool of portfolio.
2.2. Risks of Portfolio
Any asset investment has risks. The risk-taking will
have two kinds. The first kind is systematic risk, which has
close relationship with variation of economic condition. For
this reason, such risk can not be removed or dispersed so it
is called as nondiversifiable risk. The second risk is
unsystematic risk, which is produced by the factor variation
of the individual company. In the hypothesis of efficient
market, the risk can be reduced by utilizing portfolio
methods (Sharpe, 1966; Alexander et al., 1993), which is
also called as disperse risk. The general so-called portfolio
risk is to disperse risk. The purpose of portfolio theory is
with the hope of getting a fixed rate of return and disperses
risk to the lowest. Or at the certain risk, the rate of return
can achieve the highest.
The more scattered a portfolio is, the smaller risk an
unsystematic risk is. According to the statistic of Statement
(1987), When individual numbers of stocks increase in
portfolio, the standard deviation of portfolio will be greatly
diminished after stock number exceeds twenty. Therefore,
The composition factor of fitness function of GAS methods
in this research is that stock combination is limited to 20
stocks in maximum. Besides, The portfolio in this research
adopts variance or standard deviation of rate of return for
assessing the magnitude of risks.
2.3. Performance of Mutual fund
Mutual fund provides considerable advantages for
general investors in terms of capital, persons of talent, and
information. Mutual fund serves as an actual practicer, and
its investment performance becomes general investors’
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concerns and focus. Since 1960, numerous measurements
index as well as case study for fund performances have been
developed in the academic sector.
Treynor and Mazuy( 1966) discovered among 57
sample funds, no any single fund possesses remarkable
timing capability. Jensen( 1968) also discovered among
sample funds, an average of them excess return is negative.
And Chang and Lewellen (1984) discovered among sample
funds, they posses weak positive stock selection capability
and negative timing capability. Chen and Stockum (1986)
discovered among sample funds in a rather high percentage,
they posses remarkable stock selection capability. The
researches in the recent years reveal that many funds has
good stock selection capability, but in average, they are
short of timing capability (Lee and Rahman, 1990; Chen et
al., 1992) 0
Taiwanese researchers also discovered that they have
similar study result that the funds in Taiwan posses stock
selection capability but less remarkable timing capability
( Yeh Hsiu-chuan 1993; Chiu Hsien-pi 1994). The timing
capability of a fund is referred to a fund’s prediction of the
stock future, based on this to adjust either shear holding
proportion or portfolio fl coefficient capacity. Selection
capability of stock is to select an individual stock which is
expected to have high return. Consequently, it would be an
interesting research to compare a structured investment
decision making mode with a fund manager in terms of
stock selection capacity
3. Genetic Algorithms Approach
3.1 Genetic algorithms
Since Darwin brought up this theory of natural
selection, many academic discipline have been affected.
Genetic algorithms(GA) was enlightened and developed by
Holland in 1975. GA adopted the concept of seeking to
survive between living things. A string of words is used to
simulate chromosome of every living thing. According to
chromosome, fitness to environment is computed. Every
chromosome between generations to proceed crossover and
mutation at random to give a birth to next generation. Then
general environment will decide whether to live or not
according to the fitness selection of that chromosome. This
evolution will alternate and last until the final goal is
achieved.
GA utilizes three basic operation system, including
selection, crossover, and mutation.Through these three
evolution processes, Parents gives birth to a new generation.
The strongest in every generation will have higher
possibility and inherit part or all to the next generation.
(Holland, 1975, Goldberg, 1989). Thus, the basic genetic
algorithm may be summarized as follows:
Algorithm GA:
Begin
Initialize population;
Generation :=O;
Repeat
Generation = Generation + 1
 Selection(population); consider investors’ preference and requirement and didn’t
Crossover(population); correspond with the reality of the world. In addition, when a
Mutate(population); man makes decision, he possesses characteristic of bounded
Until Termination_Criterion; rationality (Douma and Schreuder, 1992). This research,
End however, considers that GA can be help inventors develop
seek solutions according to the requirement of the decision
3.2. Application of Genetic algorithms maker, overcoming men’s bounded rationality and a
GA provides a flow process of a rather simple system predicament of insufficient information.
structure. However, it can produce a strong research
capability for solutions, so powerful especially in the issue 4. Research model and Methodology
of optimum combination. (goldberg, 1989, 1994; Srinivas
and Patnaik, 1994). In the recent years, the application of 4.1 Research model
GA has been extended to finance. Such as in the study of According to the shortcoming of the above
optimizing the trade system and investment strategy conventional portfolio selection methods, we develop a user-
For example, in the investment rule of Bauer(1994), oriented investment decision making model (Figure 1) .
most of the overall economical variables are used to find out The main feature of this model is a user-oriented portfolio
the better rule combination with GA, and explore the selection model, meaning the decision making for portfolio
relations to gains in the stock market, basically regarded as a is according the user’s preference and recognition. And it is
timing strategy of basic analysis. Tayler(1995) used GA to jointly made up with selection of portfolio. As to fitness
construct an intelligent stock market model. He took time function of guiding evolution direction, we have new
series such as dividend and interests as variables, building a designs, in which influence variables are: Sharpe index .
prediction mode of stock prices. Although the study of GA EPS - user-requirement ( Industrial categories, Industrial
in the application of investment decision making has been finance capability )and numbers of stock combine, 5 items in
increasing. However, GA are rarely seen in the application total.
of portfolio. This interactive model of portfolio selection oriented
We are examining the related study in GA or by the user can find the optimum portfolio through evolution
investment decision making mode structured by the process. The optimum portfolio is selected by the model and
conventional method. The selection of investment strategy this research will test GA’s search results , stability, annual
provides the same investment mode and investment strategy, rate of return of portfolio and mutual fund, and compare
which lack of practical value. The reason is that they didn’t them with real business operators.

Figure 1 - Research Model

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4.2 Construct of model
When GA solves the real problems, it focuses on the
confirmation and understanding of a problem. Then transfer
the problem into computing form of GA. As a result, how to
encoding, select parameters, and. evolve environmental
design becomes an important research job. Therefore, this
mode1 of research and design component are stated in details
as follows:
a. Encoding : We use a string to represent a chromosome.
And encode in binary, every check indicates a bit, and
every bit represents a selection of stock - yes or no. We
have taken 107 companies with stock-entering the
market as our research target. Thus, the length of a
chromosome is 107 bits. 0 represents no selection of
that stock, and 1 represent a selection of that stock.
b. Fitness function : Fitness function is equivalent to the
environment of species revolution. As evolution goes,
the new generation will be more correspondent with the
requirement of fitness function, which indicates the
species are more adaptable to the environment. As a
result, more excellent generations are evolved. The
fitness function of the research is as follows:
Fitness function(f)=a*Sharpe index + b*EPS + c* stock
combination number +d* industrial categories + e*I
industrial finance capability
influence variables in functions are used at moment :
Sharpe index . Earnings per Share (EPS), numbers of
stock combine, industrial categories, and Industrial
finance capability. 5 items in total. Each item has its
individual weights : a=500, b=300, c=20000, d=800,
e=200. Sharpe index assesses investment combination
performance according to the unit risk size of rate of
return. (Sharpe, 1966). This mode respectively selects
individual stock nortfolio according to the user’s
L
requirement. Naturally, different individual
requirement will generate different portfolio. For
Table 2 ’ Selection mode of experiment design
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l#rqst~~$: : :,?a:;
,; ,&&$@
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“I:
~&g+&~,,~ -7 ,‘:‘ +.~~,&;~.__ .;:,,
A 1 million Foods . plastics \ textileFinancial structure * cash flow * debt
B 3 million Electrical appliance -
chemistry \ Electronic
C 5 million Foods’Electrical appliance 1
Electronic
5. Experiment Results and Discussion
Through experiments of 30 portfolio, the experiment
result is analyzed in two aspects: (1) aiming at the inherent
revolution calculation Method itself, assess the optimum
research performance. (2) Assess the annual rate of return
of portfolio, and make comparison with Taiwan mutual fund
and Taiwan stock index of annual rate of return.
example, a portfolio of 1 million is limited within 5 to
10 stocks. If within this area, 20000 points are added. If
outside of this area, the given points are on a decrease
gradually. From the familiar industrial categories, the
user can select 3 familiar industries as his main choice.
In an end, from the aspect of finance capacity, the user
can select 3 industrial finance capability from
numerous finance indexes as the appraisal focus.
c. Parameter Setting: To set up same parameter of every
group, 10 repeated tests will be carried on. Except the
beginning group is different, the rest parameters are
completely same. Thus, when discussing various
parameters to testing results, it can avoid meeting some
specific beginning group which may produce an
extreme result, then draw a biased conclusion. This
setting of testing parameters is shown in table 1.
Table 1 - GApammeters
Crossover rate 10.6
Mutation rate 10.001
4.3 Experimental Design
This experimental design feature of this research
lies in a selection of portfolio of three familiar
industries categories, habitual three finance capability
ratio, and personal preference by the user (investor).
Experimental simulation system divides the investment
amount into three groups: Group A 1 million, Group B
3 million and Group C 5 million. Table 2 appears
simulation selection of an investor. In this experiment,
each group respectively has 10 tests. So there comes 30
portfolio. The main purpose is to measure the optimum
stability of the portfolio.
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‘:(, :i’,., _, ~,:
f&K’ “’
.-;,;““Gz “““<..f.\.,: ..“.:;;“:‘::,‘: I,:, _’ ;
.:I :;r,pvmbers
5-10
paying ability
Debt paying ability . operating 11-15
ability . earning ability
Financial structure - debt paying 16-20
ability ’ earning ability
5.1 Optimum Performance of GA
The experiment result shows that GA is surely stable.
Because when the investment amount is 1 million, the
number of portfolio is controlled around 5 to 10 stocks
(table 3). When the investment amount is 3 million, the
number of portfolio can also be controlled around 10 to 15
stocks. When the investment amount is 5 million, the
number of portfolio is controlled around 15 to 20 stocks.
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The familiarity ratio of industry is finally shrunk between Sharpe index is negative value( table 4) . However the
0.3 - 0.7. annual rate of return is 20.22% p still higher than real annual
In addition, in the composition factor of GA fitness market rate of return 13.82%. Thus it can be seen that GA is
function, Sharpe index is an important factor, which shows a the optimum search capability which shows excellence of
good selection because in 30 portfolio, only a group of applying in stock selection strategy of portfolio.
Table 3 * first group fitness value ranking

8 21753 9 0.44 (4) A4

9 21743 7 0.43 (3) A5
10 21698 10 0.5 (5) Al

5.2. Performance Assessment of Portfolio
The experiment is divided into 3 groups. The first
group whose highest rate of return is 96.54% of A3, the
lowest is 20.22% of Al ( table 4 ) : The second group whose
highest rate of return is 132.63% of B7, the lowest is
50.17% of B5; The third group whose highest rate of return
is 122.95% of C5, the lowest is 57.25% of C9. The
experiment shows that portfolio has quite good performance.
Because the comparatively poor rate of return of portfolio in
the first group Al (20.22%) , still higher than Ching Hua
Finance annual rate of retum( 16.08%) which is the poorest
performance among Taiwan Mutual Fund Performance,
meanwhile, still higher than the annual rate of return
(13.82%) of Taiwan weighted stock price index.
In addition, the experiment also reveals that the
investment rate of return in group 2 is the highest, next goes
to group 3. The reason why the group 1 is the poorest is that
the stocks of portfolio have great relations to the growth of
its industry. Since the selection of industrial categories in the
first group is mostly foods, plastics, whose annual rate of
return are below 10%. Especially the rate of return of plastic
category is negative value. On the other hand, the growth
rate and annual rate of return of electronic category in 1997
is 63.48%, which is the top of six industries. Besides, the
electronic ratio of the first group is rather low (about 40%) ,
and the electronic category of the other two groups are
higher in ratio so this enables these two groups have quite
nice performance.
From the above analysis, we found a user-oriented
portfolio selection model is very significant. Because
according to human behavior, everyone has different
preferences. In other words, It is impossible for all investors
to concentrate their investment in some certain stocks.
Otherwise, the stock market will fail. For this reason, this
user-oriented portfolio selection model can not only satisfy
the investor’s preferences and requirement but also can
simulate and testify his own choice on the system
beforehand. Furthermore, adjust them to the better portfolio
before plunging into the stock market. What is more, from
different experiments of three groups, we can find out the
influence variables of fitness function, which actually bring
into full play to guidance. Especially for Sharpe index :
Because in 1997, electronic category in Taiwan enjoyed the
high rate of return. With the combination of more electronic
stock, its annual rate of return is comparatively high. This is
just what GA has brought the fitness function into full play.

Table 4 * first group fitness value assessment

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 6. Conclusion
This research applies GAS on a user-oriented portfolio
selection model to improve on conventional investment
decision making model and investment strategy. This model
enables the investor to carry on investment according to his
own requirement and preferences. The experimental results
reveal that the search of GA has stable performance, and the
objective function provides good search directions for GAS.
Especially sharpe index, the good returns of portfolios
generated by GAS show that the GA-based investment
decision making model has a practical value.
Our GA-based model is only tested in a bull market,
It performance in a bear market will be tested in future work.
Including more factors into the objective function is another
possible direction. Finally, it is worthwhile to have GAS
determine the ratio of each selected security to make this
model even more practical.
7. References
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