A hybrid approach for portfolio construction: Combing two‐stage ensemble forecasting model with portfolio optimization

Abstract

AbstractCombining the stock prediction with portfolio optimization can improve the performance of the portfolio construction. In this article, we propose a novel portfolio construction approach by utilizing a two‐stage ensemble model to forecast stock prices and combining the forecasting results with the portfolio optimization. To be specific, there are two phases in the approach: stock prediction and portfolio optimization. The stock prediction has two stages. In the first stage, three neural networks, that is, multilayer perceptron (MLP), gated recurrent unit (GRU), and long short‐term memory (LSTM) are used to integrate the forecasting results of four individual models, that is, LSTM, GRU, deep multilayer perceptron (DMLP), and random forest (RF). In the second stage, the time‐varying weight ordinary least square model (OLS) is utilized to combine the first‐stage forecasting results to obtain the ultimate forecasting results, and then the stocks having a better potential return on investment are chosen. In the portfolio optimization, a diversified mean‐variance with forecasting model named DMVF is proposed, in which an average predictive error term is considered to obtain excess returns, and a 2‐norm cost function is introduced to diversify the portfolio. Using the historical data from the Shanghai stock exchange as the study sample, the results of the experiments indicate the DMVF model with two‐stage ensemble prediction outperforms benchmarks in terms of return and return‐risk characteristics.