INTERNATIONAL JOURNAL OF COMPUTATIONAL COGNITION (HTTP://WWW.IJCC.US), VOL. 7, NO.

4, DECEMBER 2009

37

An Optimized Portfolio Allocation System Based on

Grey Theory and a Modified Markowitz MV Model
Kuang Yu Huang and I Hui Li

Abstract An automatic stock market forecasting and portfolio

selection system is proposed. In the proposed system, financial
data are collected automatically every quarter and are input
to a GM(1,1) Grey prediction model to forecast the future
trends of the collected data over the next quarter or half-year
period. The forecast data are then reduced using a GM(1,N )
model, classified using a K-means clustering algorithm, and
then supplied to a Rough Set (RS) classification module which
selects appropriate investment stocks in accordance with a predetermined set of decision-making rules. Finally, the selected
stocks are using a hybrid Grey Relational Analysis (GRA) / MVUAC scheme in order to maximize the rate of return of the stock
portfolio. The validity of the proposed approach is demonstrated
using electronic stock data extracted from the financial database
maintained by the Taiwan Economic Journal (TEJ). The portfolio
results obtained using the proposed hybrid model are compared
with those obtained from a Markowitz mean-variance (MV)
method. The effects on the rate of return of the number of
assets included within the portfolio are systematically examined
and compared. Overall, the results show that the proposed
stock selection mechanism determines the optimal portfolio which
maximizes the rate of return on the portfolio subject to the
constraints imposed by the efficient frontier defined by the MVc 2009 Yangs Scientific Research Institute,
UAC model. Copyright
LLC. All rights reserved.
Index Terms Grey theory, rough sets, Markowitz MV model,
efficient frontier, risk.

I. I NTRODUCTION

REDICTING stock prices in todays volatile markets is

notoriously difficult and represents a major challenge for
traditional time-series-based forecasting mechanisms. Consequently, a requirement exists for robust forecasting schemes
capable of generating precise predictions of the future behavior
of the stock market in order to provide investors with a reliable
indication as to where they should best invest their capital in
order to improve their rate of return.
Many applications have been proposed in recent decades
for predicting market trends. Typical applications include
the use of genetic algorithms to choose optimal portfolios [4][22], the use of neural networks to predict real-world
stock trends [9][31][2], the integration of fuzzy logic and
forecasting techniques to create artificial intelligence systems
Manuscript received June 09, 2009; revised August 10, 2009.
Kuang Yu Huang, Department of Information Management, Ling Tung
University, #1 Ling Tung Road, Taichung City 408, Taiwan. Email:
kyhuang@mail.ltu.edu.tw. I Hui Li, Department of Information Networking
and System Administration, Ling Tung University, #1 Ling Tung Road,
Taichung City 408, Taiwan. Email: sanity@mail.ltu.edu.tw.
Publisher Item Identifier S 1542-5908(09)10406-2/$20.00
c
Copyright
2009
Yangs Scientific Research Institute, LLC. All
rights reserved. The online version posted on December 22, 2009 at
http://www.YangSky.com/ijcc/ijcc74.htm

for market tracking and forecasting purposes [43][1], the use of

statistical approaches to forecast the future trends of economic
indicators [8][38][18][42][29], the application of Rough Set
(RS) theory to predict future variations in the stock market
index [45], and so on.
Grey System theory proposed by Deng [16] is a multidisciplinary theory providing the capability to deal with systems
characterized by poor, incomplete, and uncertain information.
The major components of Grey System theory include:
1) Grey prediction: the use of a Grey model to obtain a
qualitative prediction of the parameter of interest.
2) Grey relational analysis: the use of information from
the Grey system to quantify the respective effects of the
various factors within the system on the parameter of
interest in order to determine their relational grades.
The basic GM(1,1) grey prediction model [16] has been
widely applied in a diverse range of fields, including social
science [12], engineering [36], management science [23],
and so on. In recent years, various researchers have also
demonstrated the use of the GM(1,1) model as a means of
analyzing volatile stock markets and predicting their future
trends [13][33][11].
Rough Set (RS) theory was introduced more than twenty
years ago [39] and has emerged as a powerful technique for
the automatic classification of objects. RS theory has been
successfully applied in a wide variety of domains, including
machine learning, forecasting, knowledge acquisition, decision
analysis, knowledge discovery, pattern recognition, and data
mining [40][41][46][6][32]. Most RS applications are designed
to deal with classification problems of one form or another.
In constructing such applications, RS theory is generally
integrated with other theories such as Grey Systems theory [25]. Typical applications include multi-criteria classification schemes [3], stock market analysis algorithms [48][44][5],
and Variable Precision Rough Set (VPRS) models for stock
market forecasting and portfolio selection [7][26].
The current study develops a mechanism for assisting investors in predicting the future behavior of the stock market
such that they can make rational decisions as to how best to
manage their portfolio. The proposed approach combines the
GM(1,1) Grey prediction model, the GM(1,N ) multivariate
model [16], the K-means clustering technique, RS theory, Grey
Relational Analysis (GRA), the Markowitz portfolio selection
model [19][17], and the investment guidelines of Buffett
prescribed by Hagstrom etc. [21] to construct an algorithm
for forecasting financial data over a quarter or half-year period
and then predicting the stock portfolio which will maximize
the rate of return. In developing the algorithm, the standard

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INTERNATIONAL JOURNAL OF COMPUTATIONAL COGNITION (HTTP://WWW.IJCC.US), VOL. 7, NO. 4, DECEMBER 2009

Markowitz mean-variance (MV) model is extended to include

cardinality constraints which limit the portfolio to a specified
number of assets and impose constraints on the proportion
of the total available capital allocated to each selected stock.
The feasibility and effectiveness of the hybrid stock market
forecasting / portfolio selection system is demonstrated by way
of a comparison with the results obtained from the MV model.
The remainder of this paper is organized as follows. Section II presents the fundamental principles of Grey System
theory, RS theory and the optimized Markowitz portfolio
selection model, respectively. Section III describes the integration of these various concepts to construct the proposed
stock market forecasting and portfolio selection scheme. Section IV evaluates the performance of the proposed hybrid
scheme using electronic stock data extracted from the financial
database maintained by the Taiwan Economic Journal (TEJ).
Finally, Section V presents some brief concluding remarks and
indicates the intended direction of future research.
II. M ETHODOLOGIES R EVIEW
This section reviews the basic principles of the major
methodologies applied in this study to develop the proposed stock market forecasting and portfolio selection system,
namely Grey System theory, RS theory, and the optimized
Markowitz portfolio selection model.
A. Grey System theory
The main methods and models in Grey System theory
include the GM(1,1) prediction method, the GM(1,N ) multivariate model, and Grey Relational Analysis (GRA). The
details of each method / model are summarized in the subsections below.
1) GM(1,1) Prediction Method: In general, grey prediction
methods involve three basic operations, namely accumulated
generation, inverse accumulated generation, and grey modeling. The grey prediction model is constructed by using an
accumulated generation operation (AGO) to build a differential
equation of the system of interest. Intrinsically speaking,
the AGO approach has the benefit of requiring less data to
construct the model than techniques such as ARX or ANN
prediction. The process of constructing the GM(1,1) model
can be summarized as follows:
Let the original data sequence be denoted as

x(0) = x(0) (1) , x(0) (2) , x(0) (3) , , x(0) (n)

=(x(0) (k); k = 1, 2, . . . , n)
where n is the number of any time units observed.
The AGO formation of x(0) is defined as:

x(1) = x(1) (1) , x(1) (2) , x(1) (3) , , x(1) (n)

where x(1) (1) = x(0) (1), and x(1) (k) =

k
P
i=1

The solution of this differential equation is obtained using

the least-squares method, i.e.,

!
b
b

(1)
(0)
x
(k) = x (1)
e a(k1) +
a

h
i
1 T
where a
, b = B T B
B Xn and

(1)

0.5 x (1) + x(1) (2)

1

0.5 x(1) (2) + x(1) (3)

1

,
B= .
..
..
.

0.5 x(1) (n 1) + x(1) (n)

1
T

Xn = [ x(0) (2) , x(0) (3) , x(0) (4) , , x(0) (n) ] .

Let x
(0) be the fitted and predicted series, i.e.,

x
(0) = x
(0) (1), x
(0) (2), x
(0) (3), , x
(0) (n)
where x
(0) (1) = x(0) (1). Applying the inverse AGO yields

a
(0)
(0)
x
(k) = x (1)
1 e e a(k1)
a

where k = 2, 3, . . . , n, x
(0) (n + 1) , x
(0) (n + 2) , are the
so-called GM(1,1) forecast values.
2) GM(1,N ) Model: Consider a system described by
(0)
(0)
the sequences xi (k), i = 1, 2, 3, . . . , n, in which x1 (k)
describes the main factor of interest and sequences
(0)
(0)
(0)
x2 (k), x3 (k), . . . , xn (k) are the factors which influence
this main factor. Such a system can be analyzed using the
following multivariate GM(1,N ) Grey model:
(0)

x1 (k) + az (1) (k) =

N
X

(1)

bj xj (k), k = 2, 3, . . . , n,

j=2
(1)

in which xj (k) =
(1)

k
P
i=1

(0)

(1)

(1)

xj (i) and z1 (k) = 0.5x1 (k) +

0.5x1 (k 1), k 2.
(1)
Substituting all possible xj (k) terms into the
above yields a matrix of the form

(0)
x1 (2)
(0)

x1 (3)

XN = .

..

(0)
x1 (n)

(1)
(1)
(1)
z1 (2)x2 (2) . . . xn (2)
a

(1)
(1)
(1)
z1 (3)x2 (3) . . . xn (3) b2

= .
.
..
..

(1)
(1)
(1)
z1 (n)x2 (n) . . . xn (n)
bn

equation

=B
a.
x(0) (i),

k = 2, 3, 4, . . . , n.
The GM(1,1) model is then constructed by establishing the first-order differential equation of x(1) (k) as
dx(1) (k)
+ ax(1) (k) = b.
dk

1 T
Applying the matrix operation a
= BT B
B XN , the
values of bj , j = 2, 3, . . . , N can be easily found. The relative
influence exerted on the major sequence by each influencing
sequence can then be determined simply by inspecting the bj
value of the corresponding sequence.

HUANG & LI, AN OPTIMIZED PORTFOLIO ALLOCATION SYSTEM BASED ON GREY THEORY AND A MODIFIED MARKOWITZ MV MODEL

3) Grey Relational Analysis: [27] In general, Grey Relational Analysis (GRA) methods provide an effective means
of solving multiple-criteria decision problems by ranking the
potential solutions in terms of their so-called Grey Relational Grade (GRG) such that the optimal solution can be
determined. Whereas traditional statistical-based techniques
for analyzing the relationships between variables rely upon
the availability of large volumes of data and require the
factors to be expressed functionally, GRA has the advantage that it can operate with significantly less data and is
applicable to classification or decision-making problems involving many different factors. GRA therefore provides an
ideal tool for analyzing the complicated inter-relationships
amongst the individual parameters in systems with multiple performance characteristics [51][34][47][49] and has
been applied to a wide variety of optimization, decisionmaking and classification problems in such diverse fields
as finance, business, economics, design, manufacturing and
production [30][20][15][50][14][28][35][24].
In the GRA method, data characterized by the same set of
features are regarded as belonging to the same series. The
relationship between any two series of data can be determined
by evaluating the differences between them and assigning an
appropriate Grey Relational Grade (GRG).
According to Huang etc. [27], the attribute impulse factor
|xi (k)|
has the form oi (k) = |x
, where x0 and xi are the
0 (k)|
reference object and the inspected object, respectively. Furthermore, the grey relational grade is defined as
0i =

0i min

max min

where

1, 2, . . . , m,

0i

m
Q

m1
0i (k) ,

k=1

|xi (k)|
oi (k) = |x
, x0 (k) is the reference value, and xi (k) is
0 (k)|

0i and
the comparative value. Furthermore, min = min
i

0i .
max = max
i

Having calculated the GRG for each sequence, the sequences are ranked using a so-called grey relational ranking
procedure. For example, for the case of a reference sequence
x0 (k), the grey relational rank of sequence xi (k) is greater
than that of xj (k) if (x0 , xi ) > (x0 , xj ). The corresponding
ranking is denoted as xi xj .
B. Rough Set Theory
RS theory was introduced by Pawlak [39] in 1982 and provides a powerful mathematical tool for handling the vagueness
and uncertainty inherent in many decision-making processes.
RS theory is underpinned by the assumption that every object
in the universe of discourse is associated with a particular
set of information (i.e., attributes). Objects characterized by
the same information are regarded as indiscernible. The indiscernibility relationships generated amongst all the objects in
the universe of discourse provide the basic mathematical basis
for RS theory. Typical problems amenable to RS processing
include the classification of sets of objects based upon their
attribute values, checking the dependencies (full or partial)

39

between attributes, reducing the number of attributes in solving

classification problems, analyzing the significance of individual attributes, generating decision rules, and so on. In this
section we describe the basis and notions related to the rough
set theory
1) Information Systems: In RS theory, knowledge about
the universe of discourse is represented using so-called information systems. A typical information system has the form
S = (U, , Vq , fq ), where U is a non-empty set of finite
objects and is a non-empty finite set of attributes describing
each object. Here, = C D, in which C is a finite set
of conditional attributes and D is a finite set of decisionmaking attributes. For each q , Vq represents the domain
of q. Finally, fq is the information function and is given by
f : U Vq . The elements (X U ) in the information system
represent individual cases, states, processes, or observations,
for example, while the attributes (C&D) can be regarded as
the features, variables or characteristic conditions of these
elements. A decision-making table (also known as an attributevalue table) is a particular RS information system in which
the rows and columns represent elements in the universe of
discourse and the attributes of these elements, respectively.
2) Approximation of Sets: In an attribute-value table, multiple elements may be characterized by the same set of attribute
values and as a result, it is impossible to discern between them
on the basis of their attributes alone. The particular elements
which are indistinguishable from one another when applying
a selected subset of all the attributes define an equivalence or
indiscernibility relationship. In RS theory, this indiscernibility
is handled using the concept of approximate sets.
Assume that S = (U, , Vq , fq ) is a decision table in
which X U and R . The upper and lower approximates of X are denoted as R andR , respectively, and
are defined as R (X) = {Y U/IN D(R) : Y X 6= }
and R (X) = {Y U/IN D (R) : Y X}, where
U/IN D(R) expresses the equivalence of R and IN D(R)
denotes the indiscernibility of R, i.e.,
IN D(R) = {(x, y) U 2 : for every a R , a (x) = a (y)} .
The lower approximate set R (X) contains all elements
(X) of the same rank when evaluated in terms of the Y
decision-making attribute, while the upper approximate set
R (X) contains the set of all possible same-rank elements
(X) when processed in accordance with the Y decisionmaking attribute. Finally, the set BNR (X) = R (X)
R (X) is referred to as the boundary set of X.
C. Optimized Portfolio Selection Model
The portfolio selection model was proposed by
Markowitz [37] in 1952 as a means of assisting investors
in balancing their investment expectations against the
corresponding degree of risk when constructing stock
portfolios. The model is based upon the assumption that for
a given level of risk, investors will invariably attempt to
maximize their expected return, while for a given expected
return, investors will attempt to minimize their risk. In other
words, when evaluating different potential portfolios, only

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those portfolios which yield the greatest rate of return at

the same (or lower) level of risk will be considered by
the investor. Based upon these assumptions, Markowitz
proposed the concept of an efficient frontier, i.e., a curve
depicting the set of possible portfolio allocations which yield
the maximum return for any given level of risk or which
minimize the risk for any given level of return. Thus, every
portfolio lying on the efficient frontier has either a higher
rate of return for the same (or lower) risk than any portfolio
not on the curve, or a lower risk for the same (or better) rate
of return.
In the conventional Markowitz portfolio selection model, n
denotes the number of different assets within the portfolio, ri
is the mean return of asset i, ij is the covariance between
the returns of assets i and j, and [0, 1] is the risk aversion
parameter. Furthermore, the proportion of the total available
capital invested in asset i is modeled using the decision variables wi . Using these notations, the standard mean-variance
(MV) Markowitz model for the portfolio selection problem is
formulated as:
n

n P
n
P
P
minimize
wi wj ij + (1 )
ri wi , subject
i=1 j=1

i=1

to a single equivalent constraint equation

n
P

i=1

wi = 1 and n

range constraint equations 0 wi 1.

Although many previous studies have utilized this standard
MV model to optimize the allocation of assets within a
portfolio [19][17], the model does not impose constraints on
the proportion of the total available capital allocated to each
selected stock. Thus, in this study, the standard MV model is
extended to the so-called MV-UAC model by incorporating
constraints on the proportion of the total available capital
allocated to each stock within the portfolio. The ranking of
the various selected stocks obtained form the GRA method is
used to constrain decision variables wi . The additional (n 1)
un-equivalent allocation constraint (UAC) equations on the
decision variables wi are
w2 w1 0, w3 w2 0, . . . , wn wn1 0.
So, the MV-UAC model is formulated as:
n

n P
n
P
P
minimize
wi wj ij + (1 )
ri wi , subject
to

n
P
i=1

i=1 j=1

i=1

wi = 1, i = 1, 2, . . . , n and

III. O PTIMIZED P ORTFOLIO S ELECTION M ODEL

This study combines the methodologies described in Section II to create an automatic stock market forecasting and
portfolio selection system. In the proposed system, financial
data are collected automatically every quarter and are input to
a GM(1,1) prediction model to forecast the future trends of
the collected data over the next quarter or half-year period.
The forecast data are then reduced using a GM(1,N ) model,
classified using a K-Means clustering algorithm, and then
supplied to a RS classification module which selects appropriate investment stocks in accordance with a pre-determined
set of decision-making rules. Finally, the selected stocks are
processed by an integrated GRA / MV-UAC scheme in order
to determine the stock portfolio which maximizes the rate of
return. Note that in contrast to the standard MV Markowitz
model, the MV-UAC model includes additional cardinality
constraints which limit the portfolio to a specified number of
assets and impose constraints on the proportion of the total
available capital allocated to each stock within the portfolio.
The validity of the hybrid stock market forecasting / portfolio selection system is demonstrated using electronic stock
data extracted from the financial database maintained by the
Taiwan Economic Journal (TEJ). The portfolio results obtained
using the proposed systems are compared with those obtained
using the MV and the MV-UAC models. The effects of the
specified number of assets within the portfolio on the rate
of return are systematically examined and compared. Overall,
the results confirm that the proposed stock forecasting and
selection system successfully determines the optimal portfolio
which maximizes the rate of return on the invested capital
subject to the constraints imposed by the efficient frontier
defined by the MV-UAC model.
A. Use of GM(1,1) Grey Prediction Model in Preparing a
Data Set for Rough Set Processing
As described above, in the proposed stock forecasting
and portfolio selection system, financial data are collected
automatically every quarter and are then input to a GM(1,1)
prediction model to forecast their future trends over the next
quarter or half-year period this is required to put the following
discussions into context. Assuming that U is the domain of
discourse and R is the set of equivalences of U , then the
Rough Set (RS) problem can be formulated as follows:

w2 w1 0, w3 w2 0, . . . , wn wn1 0.

X U is (R (X), R (X)), BNR (X)

In the MV-UAC model, a risk aversion parameter of = 0

indicates the desire to maximize the portfolio mean return
(without considering the variance), and thus the optimal solution will comprise a portfolio containing the single asset
providing the greatest mean return. By contrast, a risk aversion
parameter of = 1 indicates the desire to minimize the total
variance associated with the portfolio (regardless of the mean
return), and thus the optimal portfolio will typically consist
of multiple assets. Clearly, any value of within the interval
(0, 1) represents a tradeoff between the mean return and the
variance, and generates a portfolio solution between those
associated with the extremes = 0 and 1, respectively.

where X is the set of elements; U/IN D(R) is the equivalence

of R; IN D(R) is the indiscernibility of R; is the zero
set; R is the attribute set of X which includes the condition
set C and the decision-making set (D); R (X) is the lower
approximate of X; R (X) is the upper approximate of X;
and BNR (X) is the boundary of X. Every element in the
domain of discourse U (X U ) has an attribute set R which
describes the particular value of X.
In the model developed in this study, every X (X
U ) of U is assigned an appropriate set of predicted conditional attribute and decision-making attribute values R =
(C1 , C2 , . . . , Cn , D1 , D2 , . . . , Dm ). The resulting attributes

HUANG & LI, AN OPTIMIZED PORTFOLIO ALLOCATION SYSTEM BASED ON GREY THEORY AND A MODIFIED MARKOWITZ MV MODEL

41

are then processed using RS theory and a hybrid GRA / MVUAC scheme to determine the optimal stock portfolio.
In the forecasting model developed in this study, each element (Xi ) in U is processed by the GM(1,1) prediction model
and assigned appropriate values of the conditional attributes
(C1 Cn ) and decision-making attributes (D1 Dm ) based
upon its trend over the previous quarter.

GRA model is used to rank the various selected stocks and

then to include cardinality constraints which limit the portfolio
to a specified number of assets. The MV-UAC model is then
applied to compute the efficient frontier imposed a specified
number of constraints on the proportion of the total available
capital allocated to each selected stock and to evaluate the rate
of return / expected risk for various points on the curve.

B. Selection of Decision-making Attributes

D. Detailed processing steps in automatic stock forecasting

and portfolio selection system

In processing the forecast data generated by the GM(1,1)

model in order to select potential stocks for inclusion in the
stock portfolio, the RS model requires a set of decision-making
attributes to determine those stocks which should at least be
considered and those which can be immediately discounted. In
the current study, these decision-making attributes are selected
in accordance with the general investment principles of Buffett
advocated by Hagstrom etc. [7][21].
Buffet asserted that enterprises characterized by attributes
such as low costs, a high profit margin, and a high
inventory turnover will enjoy financial success and hold
the lions share of the consumption market for its product
line. Furthermore, he argued that reducing costs is critical
in enabling a company to rival its competitor s in terms
of price, while high profit margins and a high inventory
turnover are both reliable indicators of the financial wellbeing of a company. Finally, he asserted that only companies
with all three attributes (i.e., low costs, a high profit margin
and a high inventory turnover) can be certain of survival
and can earn profit for their shareholders by improving the
manufacturing process, developing new products, acquiring or
merging with other enterprises, and so forth. Applying these
basic investment principles, the RS stock selection module
developed in this study implements the following decisionmaking attributes:
D1: return on asset (after tax) greater than zero
D2: return on equity greater than zero
D3: gross profit ratio greater than zero
D4: equity growth rate greater than zero
D5: quick ratio greater than median of all industry
D6: inventory turnover rate greater than median of all
industry
D7: constant EPS greater than zero.
Note that to ensure that all enterprises with a profit-making
potential are considered within the RS classification process,
the threshold values of decision-making attributes D1, D2, D3,
D4 and D7 are deliberately stated as greater than 0 rather
than being assigned a particular threshold value.
C. Optimal Allocation of Investment Portfolio
As described in the introduction to Section III, the stocks
selected by the RS module are processed by a combined
GRA / MV-UAC scheme in order to determine the stock
portfolio which maximizes the rate of return subject to the
dual constraints of a specified number of assets within the
portfolio and a specified allocation of the available capital to
each selected stock, respectively. In the proposed approach, the

The detailed processing steps in the hybrid stock forecasting

and portfolio selection system are illustrated in flowchart form
in Fig. 1. The basic steps can be summarized as follows:
Renew the Attributes
Determination

Start

Data collection and attribute determination

Data preprocessing
GM(1,1) Grey prediction
Information reduction using GM(1,N) multivariate model
K-means clustering
Selection of approximate sets
Optimized fund allocation
No
Modeling
applicable
To Proceed next
quarter investment
Yes

Yes
To continue
investment
No
End

Fig. 1: Flow chart of proposed forecasting and stock selection model.

1) Step 1: Data collection and attribute determination: In

the stock forecasting and portfolio selection system proposed
in this study, the conditional attributes of interest are those
which reflect the financial quality of a company. Therefore, the
initial company selection process is performed in accordance
with the following set of attributes: the profitability, the capitalized cost ratio, the individual share ratio, the growth rate,
the debt ratio, the operational leverage and all the statutory
financial ratios. The decision as to which of these companies
should actually be processed by the RS selection mechanism
is then made by processing the forecast data generated by the
GM(1,1) model in accordance with the seven decision-making
attributes specified in Section III-B.
2) Step 2: Data preprocessing: Having collected the relevant financial data every quarter, a basic pre-processing operation is performed to improve the efficiency of the GM(1,1)
prediction model. For example, any data records which are
incomplete (i.e., have missing attributes) are immediately
rejected. In addition, the problem of data outliers is addressed

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by using the Box Plots method [10] to establish an interquartile range such that any data falling outside this range
can be automatically assigned a default value depending on
the interval within which it is located.
3) Step 3: GM(1,1) grey prediction: A GM(1,1) forecasting
model is used to predict the future trends of the financial
variables of each of the selected companies. Note that in the
current GM(1,1) model, the forecasting process is deliberately
restricted to a one-step-ahead mode in order to prevent the
accumulation of errors from the four previous forecasting
periods.
4) Step 4: Information reduction using GM(1,N ) multivariate model: To improve the efficiency of the RS selection
process, certain conditional attributes are removed if they are
found to have little effect on the decision-making attributes.
In the system proposed in this study, this pruning operation is
performed by using a GM(1,N ) multivariate model to identify
the top ten influential sequences (i.e., conditional attributes).
5) Step 5: K-means clustering: Prior to submission to the
RS stock selection mechanism, the forecast conditional attribute values (C1 Cn ) are clustered into three groups using
a K-means clustering algorithm. The objective of clustering
is to partition the conditional attributes of stock companies
into disjoint nonempty subsets such that similar attributes
are grouped together and attributes in different subsets are
dissimilar. Each of the three clusters represent Excellent,
Common, and Poor respectively.
6) Step 6: Selection of approximate sets: Having clustered
the forecast data, the RS model is applied to determine the
lower approximate set. The generalized rules extracted by the
lower approximate set are all recognized rules or relationships
in the stock markets. And these decision rules might be helpful
to evaluate potential stocks. In the current system, the RS
model could output the potential stocks for inclusion in the
optimal portfolio.
7) Step 7: Optimized fund allocation: Having identified
suitable stocks using the RS model, an integrated GRA / MVUAC scheme is applied to determine the portfolio allocation
which maximizes the overall rate of return. As described in
Section III-C, the optimal portfolio is constructed subject to
two constraints, namely:
1) the number of assets within the portfolio;
2) the maximum allocation wi of each selected asset i.
Having completed Steps 17 above, a check is made on
the overall rate of return on the investment. If the rate of
return is judged to be acceptable, a decision is made as to
whether or not the model should be run for a further quarter
using the existing attributes. However, if the rate of return
is unacceptable, the suitability of the conditional attributes is
reviewed and the attributes are amended if necessary.
IV. E VALUATION OF P ROPOSED M ODEL U SING
E LECTRONIC S TOCK DATA
A. Data Extraction
In this study, the feasibility of the proposed forecasting and
stock selection model was evaluated using electronic stock
data extracted from the New Taiwan Economy database (TEJ).

In general, the data collection period was specified as the

second quarter in 2004 to the fourth quarter in 2006, giving
a total of 16 quarters in all. In executing the proposed stock
forecasting and portfolio selection mechanism, the total capital
available for investment was assumed to be NT$1,000,000.
B. Verification of Optimized Portfolio Selection Model
In general, financial statements for a particular accounting
period are subject to a certain delay before they are actually
published. For example, annual reports are published after
four months, half-yearly reports after two months, and first
and third quarterly reports (without notarization) after approximately one month. The submission deadlines for the financial
statements maintained in the TEJ database are as follows:
1) Annual report: the submission deadline laid down by
the Security Superintendence Commission is 4 months
after the closing balance day. However, companies listed
in previous years (TSE and OTC) can delay filing until
5/31.
2) Half-yearly report: the submission deadline laid down by
the Security Superintendence Commission is 2 months
after the closing balance day. However, companies listed
in previous years (TSE and OTC) can delay filing until
9/21.
3) First-quarter report: the submission deadline laid down
by the Security Superintendence Commission is 1 month
after the closing balance day. However, companies listed
in previous years (TSE and OTC) can delay filing until
5/31.
4) Third-quarter report: the submission deadline laid down
by the Security Superintendence Commission is 1 month
after the closing balance day. However, companies listed
in previous years (TSE and OTC) can delay filing until
11/15.
Since the last quarter data every year can not be acquired
until 31st May in the following year, the data can not be used
by the GM(1,1) model to predict the financial trends over
the first quarter of the year. In other words, the forecasting
and investing process proposed in this study can only be
conducted three times each year, i.e., 5/3109/22, 9/2211/15
and 11/1505/31 next year. In addition, in the decisionmaking rules used in the RS stock selection process, the Return
on Equity (ROE) and constant EPS indicators are based on
the full 12 months of the previous year. Thus, the forecasting
period for investment purposes is reduced to the second quarter
in 2004 to the fourth quarter in 2006.
In the following discussions, the validity and effectiveness
of the proposed stock forecasting and portfolio selection
mechanism is evaluated by way of three illustrative examples.
Executing the GRA stock priority module, two stocks (corresponding to company codes 2441 and 3017, respectively) are
selected in the third quarter in 2004. Figures 24 in the next
page illustrate the corresponding results obtained from the MV
and MV-UAC models for the efficient frontier, the correlation
between the expected return and the portfolio allocation, and
the correlation between the expected risk and the portfolio
allocation, respectively. Note that in Figs. 3 and 4, the Weight1

HUANG & LI, AN OPTIMIZED PORTFOLIO ALLOCATION SYSTEM BASED ON GREY THEORY AND A MODIFIED MARKOWITZ MV MODEL

43

and Weight2 axes indicate the relative percentage of the total

capital (NT$1,000,000) invested in the 2441 stock and the
3017 stock, respectively.

Fig. 4: Variation of expected risk with portfolio allocation ratio.

Fig. 2: MV and MV-UAC efficient frontiers for portfolio containing two stocks (2441
and 3017).

Fig. 3: Variation of rate of return with portfolio allocation ratio.

As shown in Fig. 2, the efficient frontier derived using

the standard (unconstrained) Markowitz MV method has the
form of a continuous convex shaped curve. Furthermore, it is
observed that the points along the constrained efficient frontier
derived using the MV-UAC model are a subset of those along
the unconstrained frontier. The points of former are a subset
of those along the unconstrained frontier by incorporating
constraints on the proportion of the total available capital
allocated to each stock within the portfolio. Meanwhile, Figs. 3
and 4 show that both the risk and the return increase as a
greater proportion of the total capital is invested in the 2441
stock.
In the second illustrative example, the GeoM GRA model
was integrated with the Markowitz model, and was used to
locate the efficient frontiers for portfolios containing 2, 3, 4
or 5 stocks, respectively, with no constraints imposed on the
capital allocation per stock. The corresponding results obtained
for the expected risk and rate of return when performing the

allocation decision in accordance with the points of minimum

expected risk and maximum expected return on the frontier
curve are presented in Tables I and II of the next page,
respectively.
Tables I and II show that the rate of return obtained at
the maximum expected return point on the efficient frontier is
greater than that obtained at the minimum expected risk point
for all portfolios other than that containing 4 stocks. The conventional investment wisdom which states that a greater rate of
return can be obtained by accepting a higher degree of risk is
not always right. The risks of investing stocks can be reduced
as imposing RS stock selection mechanism and a greater rate
of return can be obtained as applying the MV-UAC model.
Tables I and II also show that the level of expected risk does
not reduce as the number of selected stocks is increased. In
theory, the expected risk depends on the proportion of the total
capital allocated to each selected stock (W ) and the covariance
matrix ()of the portfolio. As shown in Table III, the average
risk ii 6= jj , i, j = 1, 2, . . . , 5, i 6= j of each selected stock
is different. Furthermore, the rate of return on each selected
stock is dependent ij 6= 0, i, j = 1, 2, . . . , 5, i 6= j on that
of the other stocks in the portfolio. Thus, the expected risk
does not decrease as the number of selected stocks increases.
TABLE III: Covariance matrix of portfolio containing 5 stocks in third quarter of 2004

0.214

0.005

0.089

0.081

0.074

0.005

0.117

-0.006

0.005

0.004

0.089

-0.006

0.161

0.072

0.065

0.081

0.005

0.072

0.147

0.046

0.074

0.004

0.065

0.046

0.127

In the third illustrative example, the return rate on a portfolio

consisting of five selected stocks is compared for four different
stock selection models, namely the standard unconstrained MV
model at the points of lowest expected risk and maximum
expected return on the corresponding frontier curve, respectively, and the constrained MV-UAC model at the points of
lowest expected risk and maximum expected return on the
corresponding frontier curve, respectively. The corresponding
results are presented in Table IV after the next pages.

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INTERNATIONAL JOURNAL OF COMPUTATIONAL COGNITION (HTTP://WWW.IJCC.US), VOL. 7, NO. 4, DECEMBER 2009

TABLE I: COMPARISON OF EXPECTED RISK AND RATE OF RETURN FOR PORTFOLIOS CONTAINING DIFFERENT NUMBERS OF SELECTED STOCKS AT MINIMUM
EXPECTED RISK POINT ON EFFICIENT FRONTIER

Lowest expected risk point of efficient frontier without allocation constrains

No. of selected stocks

2 companies

3 companies

4 companies

5 companies

expected
risk

rate of
return

expected
risk

rate of
return

expected
risk

rate of
return

expected
risk

rate of
return

2004 Second quarter

0.395

10.18

0.3415

-0.61

0.2514

-3.44

0.22851

-8.86

2004 Third quarter

0.279

-3.99

0.2481

-6.14

0.2374

-5.71

0.2271

-7.57

2004 Fourth quarter

0.4449

15.19

0.4323

15.26

0.3584

14.18

0.33387

20.90

2004Year rate of return

21.39

8.51

5.03

4.48

2005 Second Quarter

0.3243

5.23

0.3062

2.43

0.3037

1.53

0.2806

5.17

2005 Third quarter

0.2634

-0.49

0.2397

-5.59

0.1940

-2.78

0.1914

-2.10

2005 Fourth quarter

0.2227

32.74

0.2122

30.19

0.1853

24.43

0.1831

20.87

2005 Year rate of return

37.47

27.04

23.19

23.94

2006 Second quarter

0.3530

-1.53

0.3280

-1.80

0.2595

1.27

0.2391

-3.81

2006 Third quarter

0.2700

0.85

0.2240

5.21

0.2264

3.39

0.1986

1.58

2006 Fourth quarter

0.3562

50.14

0.3028

36.58

0.2503

37.91

0.2065

26.89

2006 Year rate of return

49.45

39.99

42.57

24.66

Accumulated 3 years rate of return

108.31

75.53

70.79

53.08

Average year rate of return

36.10

25.18

23.60

17.69

TABLE II: COMPARISON OF EXPECTED RISK AND RATE OF RETURN FOR PORTFOLIOS CONTAINING DIFFERENT NUMBERS OF SELECTED STOCKS AT
MAXIMUM EXPECTED RISK POINT ON EFFICIENT FRONTIER

Maximum Lowest expected return point of efficient frontier without allocation constrains
No. of selected stocks

2 companies

3 companies

4 companies

5 companies

expected
risk

rate of
return

expected
risk

rate of
return

expected
risk

rate of
return

expected
risk

rate of
return

2004 Second quarter

0.4530

22.02

0.42303

19.01

0.28466

-3.87

0.25652

-5.50

2004 Third quarter

0.4185

4.85

0.39297

3.72

0.3671

2.88

0.34055

1.13

2004 Fourth quarter

0.4841

7.94

0.50135

20.72

0.46506

19.81

0.42817

20.93

2004 Year rate of return

34.81

43.45

18.82

16.56

2005 Second Quarter

0.3434

7.02

0.3525

-2.62

0.3402

-3.08

0.3003

8.43

2005 Third quarter

0.2858

-3.25

0.2757

-12.20

0.2457

-10.35

0.2322

-8.64

2005 Fourth quarter

0.2495

24.07

0.2732

20.40

0.2722

11.92

0.2426

10.69

2005 Year rate of return

27.84

5.58

-1.51

10.48

2006 Second quarter

0.4006

11.98

0.3767

10.20

0.3469

-3.63

0.3180

6.67

2006 Third quarter

0.2883

-3.37

0.2687

-2.01

0.3393

-6.49

0.2708

-3.47

2006 Fourth quarter

0.3894

48.21

0.3626

46.60

0.3323

45.86

0.3006

42.59

2006 Year rate of return

56.82

54.78

35.74

45.79

Accumulated 3 years rate of return

119.47

103.81

53.05

72.83

Average year rate of return

39.82

34.60

17.68

24.28

The results presented in Table IV show that for both the

MV and the MV-UAC portfolio allocation models, the return
rate obtained on the basis of the maximum expected return
point on the efficient frontier is higher than that obtained on
the basis of the minimum risk point on the efficient frontier,
i.e., the rate of return obtained using method (c) is better than
that of method (a), while the rate of return obtained using
method (d) is better than that of method (b). In addition, the
rate of return obtained using the MV-UAC model is better
than that of the MV model at both points on the frontier
curve, i.e., the rate of return obtained using method (b) is
higher than that obtained from method (a), while the rate of
return obtained using method (d) is higher than that obtained
from method (c), respectively. Overall, the results presented

in Table IV confirm the efficacy of the modified MV-UAC

model in enhancing the rate of return relative to that achieved
using the conventional MV Markowitz model. Furthermore,
the results show that the portfolio allocation decision should
be based on the maximum expected return (risk) point on the
corresponding efficient frontier.
V. C ONCLUSIONS
This study has developed an automatic system for predicting
the future behavior of the stock market and constructing
portfolios which will result in the maximum rate of return.
In the proposed approach, a suitable selection of stocks for
possible inclusion in the portfolio is identified using a GM(1,1)
prediction model, a multivariate GM(1,N ) model [5], and a Kmeans clustering technique. A rough set (RS) model is then

HUANG & LI, AN OPTIMIZED PORTFOLIO ALLOCATION SYSTEM BASED ON GREY THEORY AND A MODIFIED MARKOWITZ MV MODEL

45

TABLE IV: COMPARISON OF RETURN RATE OBTAINED USING FOUR DIFFERENT STOCK SELECTION MODELS BASED ON THE MV AND MV-UAC EFFICIENT
FRONTIER CURVES RESPECITIVELY

MV with the lowest

expected risk (a)

MV-UAC with the lowest

expected risk (b)

MV with the maximum

expected return (c)

MV -UAC with the

maximum expected return (d)

rate of
return

the year
rate of
return

rate of return

the year rate

of return

rate of
return

the year
rate of
return

rate of return

the year rate

of return

2004 Second quarter

-8.86

4.48

-3.85

11.42

-5.50

16.56

11.07

30.76

2004 Third quarter

-7.57

2004 Fourth quarter

20.90

2005 Second quarter

5.17

2005 Third quarter

-2.10

2005 Fourth quarter

20.87

2006 Second quarter

-3.81

2006 Third quarter

1.58

0.85

-3.47

-0.29

2006 Fourth quarter

26.89

34.57

42.59

42.59

Accumulated 3 years
rate of return

53.08

63.64

72.83

96.50

Average year rate of

return

-4.37

1.13

19.64
23.94

1.90

20.93
20.71

-2.46

17.69

-3.92

8.43

18.57
10.48

-8.64

21.27
24.66

1.13

21.21

applied to select the stocks for inclusion within the portfolio. Finally, a hybrid GRA / MV-UAC Markowitz model is
employed to determine the optimal portfolio given a specified
number of stocks within the portfolio and constraints on the
proportion of the available capital to be allocated to each stock
within the portfolio. The major findings of this study can be
summarized as follows:
1) In theory, the expected risk of a portfolio will decrease
with an increasing number of selected stocks when
the average risk of each selected stock is the same
and the return rates of the individual selected stocks
are independent of one another. However, the results
presented in this study have shown that these conditions
do not hold in practice, and thus the expected risk does
not significantly reduce as the number of selected stocks
is increased.
2) The rate of return obtained using the constrained MVUAC portfolio allocation model is higher than that
obtained using the conventional MV model irrespective
of the point chosen on the efficient frontier (i.e., the
lowest expected risk or the maximum expected return)
when optimizing the portfolio.
3) The points lying on the efficient frontier obtained using
the MV-UAC model are a subset of those on the efficient frontier obtained using the MV model since the
former model differs from the latter only in terms of
its inclusion of some additional un-equivalent allocation
constraints.
Overall, the results presented in this study have confirmed
that the proposed stock forecasting and portfolio allocation
mechanism successfully constructs a portfolio which yields the
optimal rate of return subject to the pre-determined constraints
imposed by the efficient frontier of the MV-UAC model. In a
future study, an investigation will be performed to investigate
the relative efficacies of different GRA methods in enhancing
the ability of the MV-UAC portfolio allocation module to in-

6.67

16.76

-3.68

10.69
31.50

1.53
18.92

45.79

6.67

24.28

48.97

32.17

crease the rate of return of the portfolio whilst simultaneously

reducing the investment risk.
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