Use of lower partial moments in the asset allocation process

Abstract

Over the past years before the world financial and economic turbulences, the Baltic States have been the fastest developing economies in Europe. The Baltic insurance industry (and the Latvian one as well) was a direct beneficiary of this economic miracle. In 2002 – 2007, the local insurance market in three Baltic States doubled in volume. After the booming years insurance business suffered from the economic downturn as the income from main business operations did not show sustainable growth and companies should gain extra income from investing activities in order to stay on the market, but due to the vulnerable financial markets the return on investment decreased. So the relevance of asset allocation problem gained extra attention in the particular industry. The main purpose of the current paper is providing the foundation for the development of the ―new‖ portfolio model. The reader is going to be instructed on the essential aspects of the (μ,LPM)- portfolio model which, on the one side, enables its critical review, and on the other side, provides a platform for its later application in the practice of portfolio management. The paper is covering only the theoretical aspect of the topic. The research is concerned with the portfolio selection based on the downside risk and mean, which utilises risk measure corresponding with the risk understanding of the prevailing number of investors. As a consequence, by the portfolio optimisation based on the downside risk the chance to over-perform the reference point is not minimised as by the portfolio optimisation based on the variance.