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Determining Expected Utility and Entropy Ratio in the Expected Utility-Entropy Decision Model for Stock Selection Depending on Capital Market Development

Investment portfolio management on turbulent capital markets is a great challenge for both institutional and individual investors. They face not only great opportunities, but also considerable limitations and risks related to investments in a wide range of securities listed on global capital markets worldwide. Therefore, an appropriate securities selection is a very important step in the formation of an investment portfolio. The expected utility-entropy (EU-E) decision-making model is one of the models that can be applied to investment portfolio stock selection. The first decision-making model based on risk measure, which mixed entropy and expected utility was developed by Yang and Qiu (2005) and the same authors presented an improved version of that model with normalized EU-E measure of risk in 2014. The EU-E model combines the decision- maker's subjective preference and the objective uncertainty of the state of nature. The decision maker’s subjective preference is reflected by the expected utility and the objective uncertainty is measured using the Shannon entropy. In this model, the measure of risky action is the weighted linear average of expected utility and entropy using a risk trade-off factor. Yang, Feng and Qiu (2017) and Marasović and Kalinić (2019) proved the usefulness of the model in stock selection for investors in developed and emerging capital markets. The papers confirmed the existence of a trade-off coefficient for which the efficient frontier of the reduced set of securities gives a good enough approximation of the efficient frontier of the initial set. This method allows investors to more easily develop investment portfolios that continue to hold good properties. In this chapter, it will be tested whether the trade-off coefficient depends on capital market development. With this aim, the EU-E model was applied on European Union (EU) capital markets at different levels of development according to the FTSE equity country classification. In the analysis, three markets were taken as representative of each class: German capital market as the representative of developed markets, Hungarian capital market as the representative of advanced emerging markets and Croatian capital market as the representative of frontier markets. Emerging markets are divided into advanced and secondary emerging markets, but no EU country is classified as the secondary emerging market. It will be tested whether the EU-E model applied to the three different capital markets presented previously gives the best stock selection results for the same trade-off coefficient values, or whether the trade-off coefficient depends on capital market development. The success of the model will be tested by forming efficient portfolios, in the sense of the mean-variance model, made up of the resulting stock sets and comparing them with the efficient portfolios of the initial set for each capital market.

Investment portfolio, Stock selection, Shannon entropy, Expected utility, Portfolio optimization, EU capital markets, FTSE equity country classification

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