How does background risk affect portfolio choice: An analysis based on uncertain mean-variance model with background risk

Journal Pre-proof

How does background risk affect portfolio choice: An analysis based

on uncertain mean-variance model with background risk

Xiaoxia Huang, Tingting Yang

PII: S0378-4266(19)30299-7
DOI: https://doi.org/10.1016/j.jbankfin.2019.105726
Reference: JBF 105726

To appear in: Journal of Banking and Finance

Received date: 24 May 2019

Accepted date: 14 December 2019

Please cite this article as: Xiaoxia Huang, Tingting Yang, How does background risk affect portfolio
choice: An analysis based on uncertain mean-variance model with background risk, Journal of Banking
and Finance (2019), doi: https://doi.org/10.1016/j.jbankfin.2019.105726

This is a PDF file of an article that has undergone enhancements after acceptance, such as the addition
of a cover page and metadata, and formatting for readability, but it is not yet the definitive version of
record. This version will undergo additional copyediting, typesetting and review before it is published
in its final form, but we are providing this version to give early visibility of the article. Please note that,
during the production process, errors may be discovered which could affect the content, and all legal
disclaimers that apply to the journal pertain.

© 2019 Published by Elsevier B.V.

Highlights

• An uncertain mean-variance model with background risk is proposed to

address the uncertain portfolio with background risk.

• The effcient frontier of our model is a continuous curve composed of at

most n-1 different parabolas in the stock portfolio variance-total expected
return space, and the stock portfolio variance is a strictly increasing func-
tion of total expected return.
• Background risk has an effect on individual portfolio decisions. It changes
the variance of the stock portfolio, causing an effciency difference. The
demarcation of positive and negative of the effciency difference is the point
where investorsexpected return of background asset equals the threshold
return of total wealth.
• When investors have a background asset with higher expected return, they
will choose a less risky portfolio.

1
Title: How does background risk affect portfolio choice: An analysis based on
uncertain mean-variance model with background risk

First Author:
Xiaoxia Huang, Professor
Donlinks School of Economics and Management
University of Science and Technology Beijing, Beijing 100083, China
hxiaoxia@manage.ustb.edu.cn
+8613366296394

Second Author:
Tingting Yang, Phd candidate
Donlinks School of Economics and Management
University of Science and Technology Beijing, Beijing 100083, China
oyanglin@163.com
+8615904530827

Corresponding Author:
Xiaoxia Huang, Professor

Acknowledgment: The authors are grateful to the editor and the anonymous referees
for insightful comments that are very helpful for improving the paper. This work was
supported by National Social Science Foundation of China [17BGL052]; and National
Natural Since Foundation of China [71771023].
 How does background risk affect portfolio choice: An analysis based on uncertain
mean-variance model with background risk

Abstract
This paper explores how background risk affects individual investment decisions under the framework of uncertainty theory. We
propose an uncertain mean-variance model with background risk and give its optimal solution when the returns of stocks and
background asset obey normal uncertainty distributions. On this basis, we study the characteristic of the mean-variance efficient
frontier of the stock portfolio in the presence of background risk. Furthermore, we compare the proposed model with the uncertain
mean-variance model without background risk and discuss the efficiency difference between the two models and further give
the condition where the two models select the same stocks. Based on the comparison, we analyze how background risk affects
individual portfolio choice. Finally, we give some numerical examples as illustrations.
Keywords: Uncertainty theory; Background risk; Mean-variance optimization; Portfolio selection
JEL classification:C61

1. Introduction assets in Australia. Heaton and Lucas (2000a) obtain conclu-

Portfolio selection is about how to select among a number of
securities an optimal portfolio that can strike a balance between
maximizing the return and minimizing the risk. Markowitz
(1952) first uses the expected value and variance to represent
portfolio return and risk respectively, and presents the mean-
variance model to solve the portfolio selection problem. With
the mean-variance model, an optimal portfolio is the one with
minimum variance for a given expected return, or the one with
maximum expected return for a given variance. Since then, the
mean-variance model has become a popular criterion to help
investors to make their investment decisions.
However, Campbell (2006) indicates that the standard mean-
variance model does not perform well in explaining household
investment behavior in practice. It is worth noting that results
of the standard mean-variance model is based on the assump-
tion that investors face only portfolio risk when making portfo-
lio selection decisions. Yet investors in reality often face other
sources of risk liking variations in labor income, proprietary in-
come, income from real estate and unexpected expenses related
to health issues. These sources of risk are referred to as back-
ground risk (e.g., Gollier, 2001), and the assets that are exposed
to background risk are referred to as background assets. As
background assets are illiquid, it is hard to control background
risk by adjusting the holdings of these assets. Investors usually
pay more attention to total risk rather than solely portfolio risk
when investing. Therefore, background risk may greatly affect
individual investment decisions, which makes it necessary for
us to explore portfolio problems with background risk.
In the existing literature, scholars have done much work on
portfolio selection with background risk. Many empirical re-
sults have shown that background risk can affect investment
decisions. Cardak and Wilkins (2009) find that investors with
low labor income and poor health tend to purchase less risky
Preprint submitted to Nuclear Physics B
sions that entrepreneurial income risk has a great effect on port-
folio selection and investors tend to hold fewer stock assets
when they face a higher background risk. Cocco (2004) inves-
tigates the effect of investment in housing on portfolio choice
and shares a view that investment in housing discourages in-
vestment in stocks for younger and poorer investors. Atella
et al. (2012) show that health risk as a kind of background risk
can affect portfolio choices but the impact may be mediated by
the presence of a protective full-coverage national health ser-
vice. There is also much theoretical research on portfolio se-
lection in the presence of background risk. Heaton and Lucas
(2000b) present a decision-theoretic model for portfolio selec-
tion with background risk and get a conclusion consistent with
their earlier empirical finding that background risk plays an im-
portant role in portfolio decisions. Hara et al. (2008) prove
that background risk increases cautiousness and reveal that the
cautiousness is the key determinant of the demand for options.
Baptista (2008) provides conditions under which investors and
their managers make the same decision on portfolio selection in
the presence of background risk. In subsequent study, Baptista
(2012) adds mental accounts to portfolio selection problems
with background risk and finds that the composition and loca-
tion of such portfolios can differ notably from those of portfo-
lios on the mean variance frontier. Eichner and Wagener (2009)
analyze a decision problem with both an endogenous risk and a
background risk under mean-variance preferences framework.
Jiang et al. (2010) analyze the hedging behavior of investors
when they face background risk. Guo et al. (2018) study the
behavior of banking firm and study risk-taking behavior with
background risk in the mean-variance model. Later, Guo et al.
(2019) extend Jiang et al. (2010) by investigating the impact of
background risk on an investor’s portfolio choice in the mean-
VaR, mean-CVaR and mean-variance framework, and analyze
December 14, 2019
the characterizations of the mean-variance boundary and mean-
VaR efficient frontier in the presence of background risk. The
above studies all show that background risk greatly affects port-
folio selection. Decision without consideration of background
risk will lead to the failure of investments.
Previous studies provide insightful findings about portfolio
selection with background risk, but their conclusions are all
based on the assumption that returns of financial assets and
background asset are random variables. Hicks et al. (1979)
point out that before using stochastic method, we should first
think about whether it is applicable, and it’s not applicable in
many cases. The condition of using random variables is that
probability distributions estimated from historical data are close
enough to the real frequencies. However, in reality, there exists
the situation where no historical data are available (e.g., stocks
are newly listed). In addition, financial market is so complex
which can be affected by many factors including unexpected
events and investors’ irrational behavior. Therefore, when envi-
ronment changes fast and there are many unstable factors, even
if financial assets have a long time series of data, historical data
may become invalid and distributions estimated from historical
data still cannot be close enough to the frequencies of future
returns. This is especially true in emerging market. Similarly,
there are also situations where investors can hardly know their
future background asset return according to the historical data
in a fast changing environment. So it is worth exploring new
ways to solve portfolio selection problem with background risk
in these situations.
Black-Litterman model (Black and Litterman, 1992) is an ap-
proach that adds investors’ subjective view of the stock returns
to the historical data and forms a posterior distribution of re-
turn by Bayesian approach. It to some extent overcomes the
disadvantage of Markowitz model of using pure historical data
to determine distributions. But keep in mind that the premise of
applying probability theory is that the estimated distributions
are close enough to the real frequencies. In Black-Litterman
model, whether the posterior distribution is close enough to the
real frequencies depends on the accuracy of investors’ estimates
and the quality of historical data. If the quality of historical data
and the investors’ estimates are good enough to produce distri-
butions close enough to the future frequencies, Black-Litterman
model will be an effective way to help investors make decisions.
However, findings of Tversky and Kahneman (1986) reveal that
humans usually overweight unlikely events, which means peo-
ple’s estimations usually contain much wider range of values
than the real case and so deviate from real frequencies. Besides,
lacking of historical data or the historical data being invalid may
still exist. Thus, situation still exists where the distributions are
not close enough to the real case. Then using probability theory
to deal with the inputs will magnify the input errors. Therefore,
we explore using a new method to handle the problem.
In literature, there is much research about Knightian uncer-
tainty and portfolio selection. Knight (1921) discusses un-
certainty as a notion distinct from risk. According to Knight
(1921), the risk situation is a situation where a unique proba-
bility measure can be assigned, and the uncertainty situation is
“all other situations”. Knightian uncertainty casts doubt on the
2
assumption that the state of indeterminacy is captured by only
randomness. It makes a great process to break the monopoly
of probability theory in handling indeterminancy. However,
Knightian uncertainty is a too broad class of uncertainty be-
cause “non-probability” can represent too many things. There
is not a unique measure different from probability measure
to gauge Knightian uncertainty, and there is not a systematic
mathematical theory based on this unique measure to deal with
Knightian uncertainty situation. Although many papers have
discussed Knightian uncertainty and portfolio selection, the
mathematical interpretation of Knightian uncertainty and the
mathematical way to model Knightian uncertainty is different
from paper to paper. There is not a mathematical theory which
we can be based on to make decision in the Knightian uncer-
tainty, and in many cases, scholars still use probability measure
and probability theory to handle Knightian uncertainty, which
implies that Knightian uncertainty is not different from ran-
domness. For example, Lensberg (1999) studies an investment
behavior under Knightian uncertainty. He interprets Knightian
uncertainty as a situation that “agents have no any priori beliefs
about returns on investments and no learning rule that could be
used to arrive at such beliefs”. But he still uses a random vari-
able to express the uncertain output and employs probability to
model the obtained good state. Asano (2006) studies portfolio
selection problems under ambiguity. He regards it to be Knigh-
tian uncertainty and interprets it to be the status that a decision
maker cannot assign probabilities. He defines a probability on
a λ-system instead of on the σ-algebra and further defines an
inner measure on the λ-system probability space to model the
ambiguity.
Lacking of systematic mathematic theory to model indeter-
minancy other than randomness inspires scholars to continu-
ously search for a new measure and a new theory to handle
it. Uncertainty theory proposed by Liu (2007) is for modeling
humans’ estimations which are different from randomness. It
is developed based on four axioms and is a systematic mathe-
matic theory. Due to the different axioms and product measures
of uncertainty theory and probability theory, fundamentals and
operational laws of the two theories are different such that prob-
ability theory magnifies the input errors while uncertainty the-
ory does not. Thus, when the estimated distributions are not
close enough to the real case, we should use uncertainty theory
to help make decisions. We provide an example here to show
it. Suppose investors have 20 candidate stocks which follow
independent identical return distributions and take the uniform
distributions between [−0.15, 0]. If we can get this true distri-
butions, since the maximum return of each stock is 0, it is easy
to get that
Pr{“investment return evenly in the 20 stocks” ≥ 0} = 0.
Suppose the investors estimate the return distributions to take
uniform distributions between [−0.2, 0.8]. Please be aware that
people may quite likely to optimistically estimate the stock re-
turns in reality and we can find the examples in real life now
and then. For example, when stock of Baofeng Group Co., Ltd
(ticker: 300431) listed in Chinese stock market, at the 54 work-
ing days after its listing, the expected daily return of the stock
was 6.68% (an equivalent annual return of 2438.2%) and the
variance was 0.0037. But later, the stock return kept falling in
the subsequent three years and for the most time was less than
zero. It is quite natural that in this situation, even with great
caution and even experts’ estimates are far more precise than
the historical data, experts may still optimistically estimate the
stock returns. Then if people’s estimations are still be handled
by probability theory, it can be got by simulation that
Pr{“investment return evenly in the 20 stocks” ≥ 0} = 1.
It is seen that an investment which is sure to lose money be-
comes the investment that is sure to earn money. This is dan-
gerous because people will not prepare for a certain event and
this result may harm the investors greatly. Probability theory
magnifies the errors in the input. Next, we treat the stock re-
turns as uncertain variables and get that
M{“investment return evenly in the 20 stocks” ≥ 0} = 80%,
where M is the uncertain measure which is used to model hu-
mans’ beliefs. Though the result still deviates from the real
case, but it is due to the great errors in the input. Uncertainty
theory does not further magnify the errors in the input, and the
20% chance of losing can still alert the investors. Thus, from
the above discussion we can see that when few historical data
are available or when historical data cannot effectively reflect
the future due to fast changing environment or too many unsta-
ble factors in the environment, we should employ uncertainty
theory to help make decisions.
In the area of portfolio selection, when uncertainty theory is
put forward, Huang (2010) employs uncertainty theory to sys-
tematically propose a basic uncertain portfolio theory. Subse-
quently, Huang puts forward a series of models in the uncer-
tainty theory framework, for instance, uncertain mean-variance
and uncertain mean-semivariance models (e.g., Huang, 2012a),
uncertain mean-chance model (e.g., Huang, 2010), uncertain
mean-risk model (e.g., Huang, 2011), and uncertain mean-risk
index model (e.g., Huang, 2012b). By using uncertainty the-
ory, these studies provide different risk measures and selection
criteria for portfolio selection problem when the data are given
by experts’ estimations. Later, literature begins to appear on
portfolio selection with background risk in the framework of
uncertainty theory. Huang and Di (2016) use chance to mea-
sure risk and propose an uncertain mean-chance model with
background risk. By comparing the optimal values of uncer-
tain mean-chance models with and without background risk,
they conclude that the expected return of optimal portfolio with
background risk is smaller than that without background risk.
Zhai and Bai (2018) put forward an uncertain mean-risk model
with background risk in which risk is controlled by the criterion
of risk curve below the investor’s confidence curve. They com-
pare the optimal values of uncertain mean-risk models with and
without background risk. Then they compare the optimal solu-
tions of uncertain mean-chance model with background risk in
Huang and Di’s paper and their uncertain mean-risk model with
background risk.
3
Although Huang and Di (2016) and Zhai and Bai (2018) have
studied some uncertain portfolio selection problems with back-
ground risk under uncertainty theory, they do not use variance
as risk measurement and their papers only give the condition of
the optimal solution of their models and only compare the ex-
pected returns of portfolios with and without background risk.
No research has been done on uncertain mean-variance efficient
portfolios. The characteristic of efficient frontier of such port-
folios has not been studied either. Yet we feel variance is a pop-
ular and an important risk measurement and the mean-variance
portfolio model with background risk needs to be studied under
uncertainty theory. Furthermore, we feel the analytical solution
and the properties of the efficient frontier are the core issues.
The lack of research on these issues motivates us to do the study.
We attempt to provide deeper theoretical insights into portfo-
lios with background risk under the framework of uncertainty
theory. Our contributions to the literature are as follows. First,
we propose an uncertain mean-variance model with background
risk. Different from models using probability theory, we will
study portfolio selection problem in the new situation where
there are few past data or the past data can hardly reflect the
future stock returns and the background asset returns and so the
returns of them are given by experts’ estimations. As the situa-
tion exists in real life, and in this kind of situation, it is suitable
to apply uncertainty theory to solve the problem, it is worth-
while to explore applying a new theory to study the properties
of the new portfolio model in such a situation. Second, differ-
ent from Huang and Di (2016) and Zhai and Bai (2018), we
will use variance as risk measurement considering the popular-
ity of variance and propose an uncertain mean-variance model
with background risk. We will give the analytic solution and
will provide the shape of the efficient frontier of the optimal
portfolios with background risk. Then we will give comparison
theorems of solutions, frontiers and efficiencies of the uncer-
tain mean-variance models with and without background risk.
By comparing these two models we provide a deep understand-
ing of the impacts of background risk on portfolio investment,
which we believe is of particular interest to investors and schol-
ars.
Our paper is organized as follows. In section 2, we pro-
pose an uncertain mean-variance model with background risk,
then give its solution, and study its efficient frontier. In section
3, we compare the proposed model with the uncertain mean-
variance model without background risk and prove some prop-
erties. Base on these properties, we further discusses how back-
ground risk affects individual portfolio choice and how the ef-
fects vary as background risk varies. Section 4 provides some
numerical examples as illustrations. Section 5 concludes the
paper. Finally, the Appendix provides necessary knowledge of
uncertainty theory for readers to better understand this paper.
2. Uncertain mean-variance model with background risk
2.1. Uncertain model
In this section, we propose an uncertain mean-variance
model with background risk in which the returns of financial
assets and background assets are given by experts’ evaluations order to solve the problem, we give the deterministic form of
and treated as uncertain variables. Here, we treat various back- the model (1) to facilitate the solution.
ground assets as one background asset and study the effect
of overall level of background assets on portfolio investment. Theorem 1. Let ξb has regular uncertainty distribution Φb , and
Consider that an investor’s total wealth consists of financial ξi has regular uncertainty distribution Φi , i = 1, 2, . . . , n, re-
assets and background asset. Financial assets appear as stock spectively. Then model (1) can be transformed into the follow-
portfolio with w proportion and background asset accounts for ing form:
1 − w proportion. Since background asset cannot be adjusted in
the short term, w is fixed during the investment period.  Z 1  X 2
 n 
Let ξi represent the return of the i-th stock, i = 1, 2, . . . , n, 
 



 min w xi Φi (α) + (1 − w)Φb (α) − e dα
−1 −1
respectively, and ξi are uncertain variables. Let xi represent the 

 0
 i=1
investment proportion of the i-th stock, i = 1, 2, . . . , n, respec- 




 subject to:
tively. In this paper, we assume short selling is not allowed, 



 Z 1  X n


which is the requirement of the stock market in many countries, 
 

 w
 xi Φi (α) + (1 − w)Φb (α) dα = m
−1 −1
(2)
and so all xi are nonnegative. 

 0

 i=1
Here we use ξb to represent the return of background asset. 

 n

 X
ξb is an uncertain variable and it is independent of ξi . This is 

 xi = 1



easy to understand, e.g., health as a kind of background asset 
 i=1



is independent of stock price. Lots of literature shares a com-  x ≥ 0, i = 1, 2, . . . , n
i
mon assumption that background asset has zero expected return
(e.g., Baptista, 2008; Jiang et al., 2010; Huang and Di, 2016).
In this paper we deem that ξb doesn’t have to be zero-mean, where
because its expected value may or may not be zero in reality,
Z  n 
e.g., the expected return of background asset of a person who is 1  X 
on the rise of his or her job will have a positive expected value. e= w xi Φi (α) + (1 − w)Φb (α) dα.
−1 −1
0 i=1
One aim of our paper is to study how the effects of background
risk vary as background risk changes.
When background risk is taken into account, the total return, Proof The proof is shown in the Appendix A2.
including the stock portfolio return and the background asset Theorem 1 gives the deterministic form of the uncertain
return, can be expressed as mean-variance model with background risk in general case.
n
That is, whenever we have the the regular uncertainty distribu-
X
rT = w xi ξi + (1 − w)ξb . tions of stock returns and background asset return, we can use
i=1 Theorem 1 to get the deterministic equivalent of the model (1)
and then do further solution analysis. Considering that in appli-
Following Markowitz’s mean-variance idea, if the investor cation, returns are usually regarded to have normal uncertainty
wants to minimize the variance for a given expected return, the distributions, below we offer Theorem 2 to quickly transform
uncertain mean-variance model with background risk is as fol- the model (1) into its deterministic equivalent.
lows:
  n  Theorem 2. Suppose ξi and ξb are normal uncertain vari-


  X 



 min V w  xi ξi + (1 − w)ξb  ables, i.e., ξi ∼ N(ei , σi ), i = 1, 2, . . . , n, respectively, and




 i=1 ξb ∼ N(eb , σb ). Then model (1) can be transformed into the





 subject to: following equivalent:


  n 


  X 

 E w xi ξi + (1 − w)ξb  = m (1) 

 n
 X
2


 





i=1 


 min w  xi σi + (1 − w)σb 

 X n 




 
 i=1

 xi = 1 




 
 sub ject to :

 i=1 




 
 Xn
 xi ≥ 0, i = 1, 2, . . . , n 


 w xi ei + (1 − w)eb = m (3)



where V and E are the variance and the expected value op- 


i=1

 X n
erators of uncertain variables, and m is the investor’s desired 




 xi = 1
threshold return of the total wealth. 



 i=1



2.2. Deterministic equivalents xi ≥ 0, i = 1, 2, . . . , n.
Since model (1) contains variance and expected value oper-
ators of uncertain variables, it can not be solved directly. In Proof The proof is shown in the Appendix A2.
4
2.3. The solution The necessary and sufficient KKT optimality conditions are

∂L 1−w
= QX + σb σ − ρ1 e − ρ2 1
∂X w
The objective function of model (3) can be transformed into − λ1 A1 − λ2 A2 − · · · − λn An = 0,
the following equivalent:
m − (1 − w)eb
eT X = ,
w
 n 2 T
 X  1 X = 1,
w xi σi + (1 − w)σb 
i=1
λi ATi X = 0,
 n 2  n  ATi X ≥ 0,
X  X 
= w2  xi σi  + 2w(1 − w)σb  xi σi  + (1 − w)2 σ2b . λi ≥ 0, i = 1, 2, . . . , n.
i=1 i=1

Here, we make a statement that there are n stocks with dif-

Given that background risk is exogenous to model (3) and w is ferent excepted returns in the investor’s universe, and if ei < e j ,
fixed during the investment period, model (3) is equivalent to then σi < σ j . This assumption is based on a logic, if two stocks
model (4), have the same excepted return and variance, we think they are
the same stock; and if two stocks have the same excepted re-
  n 2  n  turn but different variances, the one with bigger variance is not


 1 X  1 − w X 



 min  
xi σi  + σb  xi σi  good enough to enter the investor’s universe; similarly the one


 2 i=1
w i=1 with lower return and bigger variance is also not good enough




 to enter the investor’s universe. The following theorems are all


 sub ject to :


 based on the statement.
 Xn

 m − (1 − w)eb

 xi ei = (4)

 w


 i=1 Theorem 3. Suppose X∗b is an optimal solution of model (3),




 Xn then X∗b = [0 0 · · · x jb · · · xkb · · · 0 0]T where


 xi = 1




 i=1  



  e − m − (1 − w)eb 
xi ≥ 0, i = 1, 2, . . . , n.  k w 
   
 x jb   e k − e j 
   
  =   . (6)
Denote X = [x1 x2 · · · xn ]T , e = [e1 e2 · · · en ]T , σ = 
 m − (1 − w)e 
xkb  b
[σ1 σ2 · · · σn ]T , Q = σσT ,  − e j 
 w 
1 = [1 1 · · · 1]T , A1 = [1 0 0 · · · 0]T , A2 = [0 1 0 · · · 0]T ,
ek − e j
. . . , An = [0 0 0 · · · 1]T where the superscript T represents the
transpose operation. Then model (4) can be transformed into
Proof The proof is shown in the Appendix A2.
the following form:
Theorem 3 gives the optimal stock portfolio of model (3),
and also provides a basis for further study of the variance and
 1 1−w


 min XT QX + σ b σT X efficient frontier of the stock portfolios. The superscript b rep-


 2 w resents the situation with background risk, a way to distinguish





 sub ject to : the situation without background risk. Equation (6) shows that



 m − (1 − w)eb (5) the optimal stock portfolio contains the j − th and k − th stocks


 eT X =

 w and their weights depend on return threshold m, the proportion





 1T
X = 1 of stocks in total wealth w, and the expected return of back-




 ground asset eb . The changes of these parameters can alter in-
ATi X ≥ 0, i = 1, 2, . . . , n. vestors’ portfolio composition. In the following we discuss how
the composition changes with each parameter respectively. We
Using Lagrange multipliers for the n+2 constraints in model (5) consider e j < ek . (i) m increases, weight of stock j decreases
respectively, then we have the Lagrangian: and weight of stock k increases. (ii) eb increases, weight of
stock j increases and weight of stock k decreases. (iii) w in-
creases, the result is the same as that of eb increases. A point is
1 T 1−w m − (1 − w)eb
L(X, ρ, λ) = X QX + σ b σT X worth noting. Once is not in this interval [e j , ek ]
2 w ! w
m − (1 − w)eb as these parameter change, stock j and stock k are not candidate
− ρ1 eT X − − ρ2 (1T X − 1) stocks. This means model (3) will choose other stocks when
w
m − (1 − w)eb
− λ1 AT1 X − λ2 AT2 X − · · · − λn ATn X. < [e j , ek ].
w
5
2.4. The efficient frontier of the stock portfolio with background
risk
Here we define the efficient frontier of the stock portfolio
with background risk as the set of portfolios with a minimum
variance for a given expected return of total wealth. Before
studying the efficient frontier, we first give the variance of opti-
mal stock portfolio.
Since the optimal stock portfolio contains the j-th and the
k-th stocks according to equation (6), ξ j and ξk are normal un-
certain variables, according to Theorem 9 in the Appendix A1,
x jb ξ j + xkb ξk is also a normal uncertain variable, and
x jb ξ j + xkb ξk ∼ N(x jb e j + xkb ek , x jb σ j + xkb σk ).
Let σ2pb denote the variance of the stock portfolio selected by
model (3), we can obtain
σ2pb = (x jb σ j + xkb σk )2 .
Substitute equation (6) into equation (7), we get the below equa-
tion
 2
 (σ − σ ) m − (1 − w)eb + (e σ − e σ ) 
 k j
w
k j j k 

σ2pb =  
 ek − e j 
where m is the desired threshold return of the total wealth.
Theorem 4. Suppose there are n > 2 candidate stocks in the
financial market to invest. Denote that e1 < · · · < eg < · · · <
eh < · · · < e j < · · · < ek < · · · < en . The efficient frontier of the
stock portfolio selected by model (3) is a continuous curve com-
posed of at most n − 1 different parabolas in the stock portfolio
variance-total expected return space, and σ2pb is a strictly in-
creasing function of eT for eT ∈ [we1 +(1−w)eb , wen +(1−w)eb ].
Proof The proof is shown in the Appendix A2.
Theorem 4 tells the shape and characteristics of efficient fron-
tier of model (3). The efficient frontier helps investors have a
panoramic understanding of the relationship between portfolio
risk and return in the present of background risk. According to
the proof of Theorem 4, when eT ∈ [we j + (1 − w)eb , wek + (1 −
w)eb ], the efficient frontier is a part of the parabola described in
equation (9),
 2
 (σ − σ ) eT − (1 − w)eb + (e σ − e σ ) 
 k j k j j k 

σ2pb =  w (9)
 .
 ek − e j 
Since our σ2pb
is a piecewise function, when eT belongs to dif-
ferent intervals, σ2pb has different forms, which makes the fron-
tier composed of different parabolas in σ2pb − eT space. Com-
paring with the traditional portfolio frontier, our frontier takes
a different form, but they are both parabola shaped.
2.5. Implications for investors
According to the above theoretical analyses, three notes are
for investors. First, investors can employ model (3) and its op-
timal solution to make investment decisions in the presence of
background risk. According to model (3), when investors set
the return threshold at m, they should select the j − th and the
k − th stocks and the proportions of the investment are deter-
mined by the equation (6). Second, variances of stock portfolios
selected by investors in the presence of background risk change
with their return thresholds. According to Theorem 4, when in-
vestors’ return thresholds increase, the variances of stock port-
folio selected by they also increase, which means that higher
return, bigger risk. The third note is for investors with differ-
ent background risk. According to different expected returns of
background asset and different proportions of background asset
in their total wealth, the riskiness of the selected stock portfolio
is different. The following is the discussion on how the vari-
(7) ance of the optimal stock portfolio changes with eb and w. The
discussions are all based on the situation that model (3) selects
the j − th and k − th stocks.
For the change of eb . The change of eb will change weights
of the stocks in equation (6), which will further change the vari-
ance of the stock portfolio in equation (8). If eb increases, the
variance will decrease in equation (8). That implies that when
(8)
investors have a background asset with higher expected return,
they will choose a less risky portfolio. The result may surprise
you at first, but it is consistent with practices of investors. When
investors own background asset with a higher expected return,
they usually face larger background risk. Under this circum-
stance, investors will choose a less risky stock portfolio.
For the change of w, there are three situations. (i) eb = m. In
equation (6), weights of stocks do not change with w. Similarly,
the stock portfolio variance does not change with w in equa-
tion (8). This means that when eb = m, investors will choose
the same stock portfolio no matter how w varies. (ii) eb > m.
The stock portfolio variance in equation (8) decreases as w de-
creases. That means if investors have this kind of background
asset, the more proportion of background asset in their total
wealth, the less risky portfolio they will choose. (iii) eb < m.
The portfolio variance in equation (8) increases as w decreases.
That implies if investors have this kind of background asset, the
more proportion of background asset in their total wealth, the
more risky portfolio they will choose.
3. Comparison of the proposed model with the uncertain
mean-variance model without background risk
3.1. Comparison of the optimal solutions of the two models
Without the consideration of background risk, the total return
P
can be expressed as rT = ni=1 xi ξi . From the model (3) we see
that when ξi are normal uncertain variables, i.e., ξi ∼ N(ei , σi ),
i = 1, 2, . . . , n, respectively, the uncertain mean-variance model
without background risk is
6
   n 2 3.2. Comparison of the efficient frontiers of the two models


 X  According to Theorem 4, the efficient frontier with back-


 min 
 x i i
σ 

 

 i=1
ground risk is a continuous curve composed of at most n−1 dif-




 ferent parabolas. Similarly, the efficient frontier without back-


 subject to:


 n
ground risk is also a continuous curve composed of at most n−1

 X

(10) different parabolas. So what is the relationship between them?

 xi ei = m






i=1
Theorem 6. The efficient frontier with background risk and that


 X n


 without background risk intersect at the point where eb = m,


 xi = 1

 and when eb < m, the efficient frontier with background risk is


 i=1

 on the right of efficient frontier without background, and when
xi ≥ 0, i = 1, 2, . . . , n
eb > m, the efficient frontier with background risk is on the left
where m takes the same value as in model (3). The solution pro- of efficient frontier without background.
cess is similar to that of model (3). Let X∗ denote the optimal
solution of model (10). We get X∗ = [0 0 · · · x s · · · xt · · · 0 0]T Proof The proof is shown in the Appendix A2.
where Theorem 6 gives the locations of efficient frontiers with and
without background risk and tells the relationship of frontiers
 et − m  with and without background risk. According to Theorem 6, we
 
" #  e − e  have Figures 1, 2 and 3. As shown in Figure 1, the solid curve
xs  t s 
=  . (11) is the efficient frontier without background risk and the dashed
xt  m − e s 
  curve the frontiers with background risk, and the two frontier
et − e s intersect at the point where eb = m. When eb < m, σ2pb > σ2p ;
Equation (6) and equation (11) represent the optimal solutions and when eb > m, σ2pb < σ2p . If eb increases, say changing
of the two models. Is there a situation that the two models select from eb1 to eb2 , as shown in Figure 2, the new efficient frontier
the same stocks? The following theorem answers the question with background risk (eb2 ) will be above the original frontier
above. with background risk (eb1 ). If w increases, say changing from
m − (1 − w)eb w1 to w2 , as shown in Figure 3, the new efficient frontier with
Theorem 5. If e j ≤ ≤ ek and e j ≤ m ≤ ek , background risk (w2 ) changes in a way like counterclockwise
w
model (3) and model (10) both select the j − th and the k − th rotation.
stocks.

Proof The proof is shown in the Appendix A2.

With background risk
m − (1 − w)eb
According to Theorem 5, when e j ≤ ≤ ek and Without background risk
w
e j ≤ m ≤ ek , model (3) and model (10) both select the j − th
Expected return of total wealth

and the k − th stocks, so the optimal solution X∗ of model (10)

can be transformed into the following form:

X∗ = [0 0 · · · x j · · · xk · · · 0 0]T
eb
where
 ek − m 
 
" #  ek − e j 
xj  
=  . (12)
xk  m − e j 
  Variance of stock portfolio
ek − e j
Theorem 5 provides the basis for comparing equations (6)
Figure 1: Efficient frontiers with and without background risk.
and (12), which are the optimal solutions with and without
background risk, respectively. Observing these two equations,
it is worth noting that even when stocks in the two optimal so-
lutions are same, their weights are different. This reveals that 3.3. Comparison of efficiencies of the two models
background risk indeed alter investors’ portfolio selection. We Here, we define the standard deviation as stock portfolio’s
consider e j < ek . If eb > m, investors increase the investment efficiency, and the efficiency difference between model (3) and
on stock j when considering background risk. If eb < m, in- model (10) is the difference between standard deviations of two
vestors decrease the investment on stock j when considering portfolios when the expected returns of the total wealth in the
background risk. If eb = m, background risk does not alter two models are the same, i.e., the efficiency difference ∆σ =
investors’ portfolio composition. σ pb − σ p .
7
 3, with the increase of w, the efficient frontier with background
With background risk (eb1) risk changes like counterclockwise rotation, the absolute value
With background risk (eb2) of efficiency difference becomes smaller.
Without background risk
Expected return of total wealth

We have discussed the efficiency difference between the two

models in general situation. So what is the efficiency difference
when two models select the same stocks? The following will
answer it.
eb2
Lemma 1. If model (3) and model (10) both select the j − th
eb1 and k − th stocks, the efficiency difference between model (3)
and model (10) is
1−w
(m − eb )(σk − σ j )
4σ = σ pb − σ p = w . (13)
Variance of stock portfolio ek − e j

Proof The proof is shown in the Appendix A2.

Figure 2: Efficient frontiers with background risk for different eb0 s. Lemma 1 gives the specific mathematical expression of the
efficiency difference between models with and without back-
ground risk. From the mathematical expression, we can know
With background risk (w=w1<w2) how the efficiency difference changes with eb and w. For this
Expected return of total wealth

With background risk (w=w2)

Without background risk
purpose, we get the derivatives of equation (13) which are
1−w
∂4σ (σk − σ j )
=− w , (14)
eb ∂eb ek − e j
∂4σ 1 (m − eb )(σk − σ j )
=− 2 . (15)
∂w w ek − e j

According to equation (14), we know if eb changes one unit,

Variance of stock portfolio
Figure 3: Efficient frontiers with background risk for different w0 s.
Theorem 7. When m , eb , there is an efficiency difference
between model (3) and model (10), and the difference increases
with eb decreases.
Proof The proof is shown in the Appendix A2.
Theorem 8. When m > eb , the efficiency difference between
model (3) and model (10) increases with w decreases, and when
m < eb , the difference increases with w.
Proof The proof is shown in the Appendix A2.
Theorems 7 and 8 tell the influence of background risk on
the portfolio efficiency from the perspectives of expected return
of background asset and the proportion of background asset in
the initial total wealth. As seen in Figure 1, when eb < m,
there is a positive efficiency difference between models with
and without background risk, imply investors choose a portfo-
lio with a bigger variance when considering background risk.
And when eb > m, there is a negative efficiency difference, im-
ply investors choose a portfolio with a smaller variance when
considering background risk. And when eb increases, as shown
in Figure 2, from eb1 to eb2 , the difference decreases. In Figure
8
(1 − w)(σk − σ j )
the efficiency difference changes − units. Ac-
w(ek − e j )
cording to equation (15), if w changes one unit, the efficiency
(m − eb )(σk − σ j )
difference changes − w12 units. This two re-
ek − e j
sults coincide with Theorems 7 and 8.
From the above analyses, we can see that background risk has
an effect on individual portfolio decisions indeed. Even when
investors choose the same stocks in their portfolio with back-
ground risk as they choose without considering background
risk, background risk changes the variance of the stock port-
folio, causing an efficiency difference. The demarcation of pos-
itive and negative of the efficiency difference is the point where
eb = m. And the difference changes with eb and w.
3.4. Implications from the comparisons
(i) When investors’ expected return of background asset
equals the threshold return of total wealth, background risk does
not affect individual portfolio decisions. When their expected
return of background asset is smaller than their threshold return
of total wealth, with consideration of background risk, investors
choose a more risky stock portfolio. When their expected return
of background asset is bigger than their threshold return of total
wealth, with consideration of background risk, investors choose
a less risky stock portfolio.
(ii) When the expected return of background asset is close
to the threshold return of total wealth, the absolute value of
efficiency difference is small, implying background risk has a
small effect on portfolio choice. When the expected return of (2012a). The interested readers can refer to it. Besides, the ex-
background asset is far from the threshold return of total wealth, perts believe that the background asset return has uncertainty
the absolute value of efficiency difference is big, the decision- distribution ξb ∼ N(0.015, 0.005).
making bias will be caused if background risk is not taken into
Table 1: Uncertain distributions of ξi
account.
(iii) The greater the proportion of background assets, the Stock i Code Distribution
greater the impact of background risk on investors. 1 600009 N(0.0250, 0.0400)
Note that our results coincide with the reality. It is well 2 600729 N(0.0310, 0.0450)
known that households face specific sources of background 3 600498 N(0.0420, 0.0630)
risk and have a different ratio between background assets and 4 000877 N(0.0450, 0.0810)
total wealth from those of other households. Our uncertain 5 000997 N(0.0600, 0.0920)
model helps to explain the great cross-sectional variations in 6 600547 N(0.0700, 0.0950)
household financial asset holdings observed in the empirical
literature. Though this difference has also been explained un-
der probability theory framework (Campbell, 2006), please be
aware that our study is done under a different situation from 4.2. The effect of background risk on portfolio choice
randomness. Since there is much indeterminacy in the finan- If the investor decides to set the return threshold at 0.04, he
cial market, and random is just one type of it, our approach is or she should choose the portfolio according to the following
important to investors. When the condition of using random model,
variables and probability theory is not satisfied, it is worth ex- 


 min [0.8(0.0400x1 + 0.0450x2 + 0.0630x3 + 0.0810x4
ploring a new way to solve portfolio selection problems with 




 + 0.0920x5 + 0.0950x6 ) + 0.2 × 0.005]2
background asset. Uncertainty theory approach provides an ac- 




ceptable method to deal with the indeterminacy of humans’ es- 

 sub ject to :


timations. Our approach is complementary to Markowitz model  0.8(0.0250x1 + 0.0310x2 + 0.0420x3 + 0.0450x4


rather than competitive. When data are valid, Markowitz model 




 + 0.0600x5 + 0.0700x6 ) + 0.2 × 0.015 = 0.04
should be used; and when data are invalid, uncertain portfo- 



lio approach should be used. The two approaches can help in- 

 x 1 + x2 + x 3 + x4 + x5 + x6 = 1



vestors make decisions in different types of indeterminacy. xi ≥ 0, i = 1, 2, . . . , 6.
By using MATLAB2016, the optimal stock portfolio is ob-
4. Numerical example tained and provided in Table 2. As can be seen from Table 2,
the investor should choose the second and sixth stocks when
In order to illustrate how to make individual investment de- considering background risk, and the proportions are 0.609 and
cisions in the presence of background risk and show the effects 0.391, respectively. The variance of the optimal stock portfolio
of background risk on investments, we give a real portfolio se- is 0.0042 and the standard deviation is 0.0646.
lection with background risk example. To compare the uncertain mean-variance models with and
without background risk, we set the threshold at the same level
4.1. The data of 0.04 and select the stock portfolio again without considera-
Consider an investor whose total wealth consists of 80 per- tion of background risk. The results are provided in Table 3.
cent stocks and 20 percent background asset. Suppose he/she As can be seen from Table 3, the investor chooses the second
is determining how to make portfolio investment on June 3, and sixth stocks, but the proportions of investment are 0.7692
2019 and August 30, 2019 is the end of the investment horizon. and 0.2308. Its variance and standard deviation are 0.0032 and
The six candidate stocks come from Shanghai Stock Exchange 0.0565, respectively.
and Shenzhen Stock Exchange through fundamental analysis.
Since the outbreak of Sino-US trade war, the economic en- Table 2: Optimal stock portfolio with background risk.
vironment has changed rapidly. Thus, the historical data are Stock i Proportion Stock i Proportion
believed to be invalid in reflecting the future. Then two do- 1 0 4 0
main experts who are analysts in two different reputable in- 2 0.6090 5 0
vestment banks are invited to estimate the stock return distri- 3 0 6 0.3910
butions. The experts give the chance of the stock return less
than a certain value. For example, an expert gives an estima-
tion data (0.04, 0.7) which means that the chance of the stock Observing Table 2 and Table 3, we find some results. (i)
return less than 0.04 is 0.7. By using the least squares principle Stocks selected by the models with and without background
(Liu, 2010) , the uncertainty distributions of the stock returns risk are the same. The investor selects the second and the sixth
are got. Table 1 shows the data in quarterly return because the stocks no matter with or without background risk. However,
investment period is three months. The specific process for ob- their weights are different. In Table 2, the proportions of invest-
taining the uncertainty distributions has been given in Huang ment are 0.6090 and 0.3910, while in Table 3, the proportions
9
 Table 3: Optimal stock portfolio without background risk. 0.07
Stock i Proportion Stock i Proportion With background risk
0.065 Without background risk
1 0 4 0
0.06
2 0.7692 5 0

Expected return of total wealth

3 0 6 0.2308 0.055

0.05

0.045

0.04
of investment are 0.7692 and 0.2308. It can be seen that back-
ground risk changes the proportion of the investor’s investment. 0.035

(ii) The efficiency difference between the two portfolio is 0.03

4σ = σ pb − σ p = 0.0646 − 0.0565 = 0.0081. When facing 0.025

background risk whose expected return is 0.015 (eb < m), the
0.02
investor changes the investment proportion and chooses a stock 0 0.001 0.002 0.003 0.004 0.005 0.006 0.007 0.008 0.009 0.01
portfolio with higher risk level. Variance of stock portfolio

(iii) Figure 4 shows the location of efficient frontiers of stock

Figure 5: Efficient frontiers of optimal stock portfolios in the two models (when
portfolios with and without background risk in σ2pb − eT space. eb = 0.04).
The dashed parabola shows the efficient frontier of stock port-
folio with background risk and the solid parabola shows the ef-
ficient frontier of stock portfolio without background risk. Ac- 4.3. Sensitivity analysis with background risk
tually, the two efficient frontiers does not intersect because the
To study how the effects vary with background risk, we
expected return of total wealth (eT ) is always bigger than the
change the values of eb and w, do experiments again, and pro-
expected return of background asset (eb = 0.015). But the
vide the results in Tables 4 and 5. The results show that in-
efficiency difference between the two models becomes more
vestors choose different risk levels of stock portfolios according
smaller as the expected return of total wealth comes more closer
to different eb ’s and w’s. Table 4 shows how the effects of back-
to 0.015. Figure 5 shows the situation that two efficient fron-
ground risk vary with eb . In Table 4, when the expected return
tiers intersect at a point. Similarly, the dashed parabola shows
of background asset is 0.01, the standard deviation of optimal
the efficient frontier of stock portfolio with background risk and
portfolio is 0.0662; when the expected return of background
the solid parabola shows the efficient frontier of stock portfolio
asset gradually increases to 0.04, the standard deviation of op-
without background risk. All else unchanged, the distribution
timal portfolio is 0.0534. It can be seen that when eb increases,
of ξb changes to N(0.04, 0.012), and the two efficient frontiers
the standard deviation of the optimal portfolio decreases. If eb is
intersect at the point where the expected return of total wealth
bigger than m, the investor changes the investment proportion
(eT ) equals the expected return of background asset (eb = 0.04).
and chooses a less risky portfolio and there is a negative effi-
All the results are consistent with our theoretical analysis.
ciency difference. If eb is smaller than m, the investor chooses a
more risky portfolio and there is a positive efficiency difference.
Table 5 shows how the effects of background risk vary with
0.07
With background risk
w. There are three situations in Table 5. (i) eb = 0.04 = m.
0.065 Without background risk When w = 0.6, the standard deviation of the optimal portfolio
0.06 is 0.0565; when w = 0.7 and w = 0.8, the standard deviations of
the optimal portfolio are both 0.0565. Therefore, under this sit-
Expected return of total wealth

0.055
uation, background risk dose not change investment decisions
0.05 no matter how w varies.
0.045 (ii)eb = 0.05 > m. When w = 0.6, the standard deviation of
the optimal portfolio is 0.0480; when w gradually increases to
0.04
0.8, the standard deviation of the optimal portfolio is 0.0534. It
0.035
can be seen that the standard deviation of the optimal portfolio
0.03 increases with w. This means that if the investor has less back-
0.025
ground assets like this kind in his or her total wealth, he or she
chooses a more risky portfolio.
0.02
1 2 3 4 5 6 7 8 9 10 (iii)eb = 0.03 < m. When w = 0.6, the standard deviation
Variance of stock portfolio 10-3 of the optimal portfolio is 0.0651; when w gradually increases
to 0.8, the standard deviation of the optimal portfolio is 0.0598.
Figure 4: Efficient frontiers of optimal stock portfolios in the two models (when The portfolio standard deviation decreases as w increases. It
eb = 0.015).
implies that when the investor has less background assets like
this kind in his or her total wealth, he or she chooses a less
10
risky portfolio. The results are consistent with Theorems 7, 8 and random environment. As seen in Table 7, the optimal port-
and Lemma 1 . folio under uncertain environment is (0, 0.609, 0, 0, 0, 0.391)T
and its return is 8.38%, while the optimal portfolio under ran-
Table 4: Standard deviations of stock portfolios for different expected
dom environment is (0.1344, 0, 0.4043, 0.2123, 0.2490, 0)T and
returns of background asset
its return is 4.67%. Portfolio return when returns are uncertain
eb 0.01 0. 02 0.03 0.04 0.05 variables is greater than the one when returns are random vari-
σ pb 0.0662 0.0630 0.0598 0.0565 0.0534 ables (8.38% > 4.67%).
σp 0.0565 0.0565 0.0565 0.0565 0.0565 Why is there such a result? It is because unexpected events
σ pb − σ p 0.0097 0.0065 0.0033 0 -0.0031 and fast changing environment invalidate the historical data so
Note: m = 0.2, w = 0.8. that no future frequencies of the security returns can be got from
historical data. Therefore, in this situation, it is more appropri-
ate to make use of experts’ knowledge and experience to have
the distributions of the stock returns. However, as studies have
Table 5: Standard deviations of stock portfolios for different proportions of
background asset
revealed that people often overweight unlikely events, humans’
estimations usually cannot be so exact as in the real case. Due
w 0.6 0.7 0.8 to the different axioms and product measures of probability the-
σ pb 0.0565 0.0565 0.0565 ory and uncertainty theory, fundamentals and operational laws
eb = 0.04 = m
σ pb − σ p 0 0 0 of the two theories are different such that probability theory will
σ pb 0.0480 0.0511 0.0534 magnify the input errors while uncertainty theory will not. Then
eb = 0.05 > m
σ pb − σ p -0.0085 -0.0054 -0.0031 the decision made based on uncertainty theory is better than on
σ pb 0.0651 0.0620 0.0598 probability theory in this situation. Thus, when the estimated
eb = 0.03 < m
σ pb − σ p 0.0086 0.0055 0.0033 distributions are not close enough to the real case, we should
use uncertainty theory. Uncertainty theory can help investors
make decisions effectively in such a kind of indeterminacy sit-
uation.
4.4. Comparison of results using uncertainty theory and prob-
ability theory
In the above example, since historical data are not believed 5. Conclusion
to provide effective guidance, experts are invited to give their
estimations and uncertainty theory is used as the tool. What will
This paper has studied how background risk affects indi-
happen if we misuse probability theory in the above situation?
vidual investment decisions when returns of stocks and back-
Now the returns of the same six candidate stocks and the ground asset are given by experts’ evaluations. Treating these
background asset, denoted by ri and rb respectively, are treated returns as uncertain variables, we have proposed an uncertain
as normal random variables. Historical data from June 1, 2007 mean-variance model with background risk and have presented
to May 31, 2019 are used to estimate probability distributions its optimal solution when the returns of stocks and background
of ri which are shown in Table 6. Data of residents’ disposable asset obey normal uncertainty distributions. Based on the so-
income from China Statistical Bureau is used to get the dis- lution, we have given the characteristic of the mean-variance
tribution rb ∼ N(0.02, 0.0032 ) of the background asset return. efficient frontier of the stock portfolio in the presence of back-
Similarly, the return threshold is set at the same level of 0.04. ground risk. Furthermore, we have compared the proposed
Using Markowitz’s mean-variance model, we get the optimal model with the uncertain mean-variance model without back-
stock portfolio (0.1344, 0, 0.4043, 0.2123, 0.2490, 0)T . ground risk and discussed the efficiency difference between the
two models. Based on the comparison, we have analyzed how
Table 6: Probability distributions of ri background risk affects individual portfolio choice. Finally, nu-
Stock i Code The expected return Variance merical examples have illustrated our findings.
1 600104 0.0317 0.0539 There are many things to do in the future. In this paper we
2 600729 0.0228 0.0420 assume that stock returns are independent. However, it is very
3 600498 0.0419 0.0530 well known that some stocks, funds or market indices are cor-
4 000877 0.0489 0.0938 related. It means that the variables are not independent. When
5 000997 0.0274 0.1010 variables are not independent, they can be converted into inde-
6 600547 0.0539 0.0859 pendent variables by using the factor method mentioned in the
paper (Huang and Zhao, 2014). Then the results of this paper
is still valid. In the future the research on uncertain portfo-
The expected returns of optimal stock portfolios under uncer- lio selection when the variables are not independent is one of
tainty theory framework and probability theory framework are our directions. In the future research, we will also consider the
the same, but how the two portfolios perform in reality? Table case where stock returns are modeled in a probabilistic way and
7 shows portfolio performances under uncertain environment background risk in an uncertainty framework.
11
 Table 7: Comparison of optimal stock portfolios under two theory frameworks
Stock i Code Return in Proportion under Proportion under
investment period uncertain environment random environment
1 600104 2.79% 0 0.1344
2 600729 3.42% 0.6090 0
3 600498 4.27% 0 0.4043
4 000877 5.47% 0 0.2123
5 000997 5.67% 0 0.2490
6 600547 16.1% 0.3910 0
Portfolio Return 8.38% 4.67%

Acknowledgment Definition 1. (Liu, 2007) Let ξ be an uncertain variable. Then

the expected value of ξ is defined by
This work was supported by National Social Science Foun-
dation of China No. 17BGL052 and National Natural Science Z ∞ Z 0
Foundation of China No. 71771023. E[ξ] = M{ξ ≥ r}dr − M{ξ ≤ r}dr (17)
0 −∞

Appendix provided that at least one of the two integrals is finite.

A1. Uncertainty Theory Theorem 10. (Liu, 2010) Let ξ be an uncertain variable with a
Let us review some necessary knowledge about the uncer- regular uncertainty distribution Φ. If its expected value exists,
tainty theory. then
Z 1
Uncertainty theory is an axiomatic mathematics that mod-
E[ξ] = Φ−1 (α)dα. (18)
els human uncertainty. Uncertain measure, denoted by M, is 0
defined based on four axioms of uncertainty theory (e.g., Liu,
2007) and is proved to be increasing (e.g., Liu, 2010). An un- The variance of an uncertain variable is defined as follows.
certain variable is a measurable function ξ from an uncertainty
space (Γ, L, M) to the set of real numbers and is characterized Definition 2. (Liu, 2007) Let ξ be an uncertain variable with
by uncertainty distribution. finite expected value e. Then the variance of ξ is defined by
Normal uncertain variable is the variable that has the follow-
ing normal uncertainty distribution V[ξ] = E[(ξ − e)2 ]. (19)
!!−1
π(e − t) Theorem 11. (Yao, 2015) Let ξ be an uncertain variable with
Φ(t) = 1 + exp √ , t ∈ <, a regular uncertainty distribution Φ and finite expected value
3σ
e.Then
where e and σ are real numbers and σ > 0. For convenience, Z 1
it is denoted in the paper by ξ ∼ N(e, σ). An uncertainty dis- V[ξ] = (Φ−1 (α) − e)2 dα. (20)
0
tribution Φ(t) is called regular if it is a continuous and strictly
increasing function with respect to t at which 0 < Φ(t) < 1, and For more expositions on uncertainty theory, the interested
lim Φ(t) = 0, lim Φ(t) = 1. It is seen that normal uncer- readers can consult the book Liu (2010).
t→−∞ t→+∞
tainty distribution is regular.
The operational law is given by (e.g., Liu, 2010) as follows: A2. Proofs of Theorems
Theorem 9. (Liu, 2010) Let ξ1 , ξ2 , . . . , ξn be independent
Proof of Theorem 1
uncertain variables with regular uncertainty distributions P
Let Ψ denote the uncertainty distribution of w ni=1 xi ξi + (1 −
Φ1 , Φ2 , . . . , Φn , respectively. Let f (t1 , t2 , · · · , tn ) be strictly in- Pn
w)ξb . Since w i=1 xi ξi + (1 − w)ξb is strictly increasing with ξi
creasing with respect to t1 , t2 , . . . , tn . Then
and ξb , according to Theorem 9 in the Appendix A1, the inverse
ξ = f (ξ1 , ξ2 , · · · , ξn ) uncertainty distribution of Ψ is

is an uncertain variable with inverse uncertainty distribution

n
X
function
Ψ−1 (α) = w xi Φ−1 −1
i (α) + (1 − w)Φb (α), 0 < α < 1.
−1
Ψ (α) = f (Φ−1 −1
1 (α), Φ2 (α), · · · , Φ−1
n (α)), 0 < α < 1. (16) i=1

The expected value of an uncertain variable is defined as fol- Then according to Theorem 10 and Theorem 11, the expected
P
lows: value and variance of w ni=1 xi ξi +(1−w)ξb are given as follows
12
respectively. which are equivalent to
 n 
 X  
E w xi ξi + (1 − w)ξb  


 σ21 x1 + σ1 σ2 x2 + · · · + σ1 σn xn − ρ1 e1 − ρ2 − λ1 = −
1−w
σb σ1


 w
i=1 

Z 

 1 − w
1 


 σ2 σ1 x1 + σ22 x2 + · · · + σ2 σn xn − ρ1 e2 − ρ2 − λ2 = − σb σ2
= Ψ−1 (α)dα = e 




w
0


 .
 ..
Z 1  X n







 

= w xi Φ−1
i (α) + (1 − w)Φ−1
b (α)  dα, 


 σn σ1 x1 + σn σ2 x2 + · · · + σ2n xn − ρ1 en − ρ2 − λn = −
 1−w
σb σn
0 i=1 
 w


 n  

 m − (1 − w)eb
 X  

 e1 x1 + e2 x2 + · · · + en xn =
xi ξi + (1 − w)ξb 
 
 w
V w 





 x1 + x2 + · · · + xn = 1
i=1 


Z 

1 
 λx =0 (I)
 i i


= (Ψ−1 (α) − e)2 dα 



 xi ≥ 0
0 

 λ ≥ 0, i = 1, 2, . . . , n.
Z  n 2 i
1  X  (21)
= w xi Φi (α) + (1 − w)Φb (α) − e dα.
−1 −1
Define q as the number of λi which equals 0. Next we discuss
0 i=1
how the optimal solution changes with q.
So Theorem 1 is proved. (i) q = 0. According to the constraint (I) in the equation set
Proof of Theorem 2 (21), all xi = 0. So no solution to the equation set (21).
According to Theorem 9 in the Appendix A1, it can be
(ii) q = 1. Let the o-th λ equals zero, i.e., λo = 0 . The
proven that when ξi and ξb are normal uncertain variables,
P equation set (21) can be transformed into the following equation
w ni=1 xi ξi + (1 − w)ξb is also a normal uncertain variable, and
set (22). It is quite clear that there is no solution to equation set
(22) because the constraint (II) and constraint (III) cannot be
n
X satisfied at the same time.
w xi ξi + (1 − w)ξb
i=1
 n n

 X X 
∼ N w xi ei + (1 − w)eb , w xi σi + (1 − w)σb  . 
i=1 i=1 
 1−w


 σ1 σo xo − ρ1 e1 − ρ2 − λ1 = − σb σ1


 w

 1−w
For a normal uncertain variable ξ ∼ N(e, σ), we can calculated 



 σ2 σo xo − ρ1 e2 − ρ2 − λ2 = − σb σ2
that its expected value E[ξ] = e and variance V[ξ] = σ2 . So the 

 w
P 

expected value and variance of w ni=1 xi ξi + (1 − w)ξb are 


 ..


 .
 n  


 X  n
X 

 2 1−w
E w xi ξi + (1 − w)ξb  = w xi ei + (1 − w)eb ,


 σo xo − ρ1 eo − ρ2 = − σb σo


 w
i=1 i=1 



 ..
 n   n 2  .
 X   X  
 (22)
V w xi ξi + (1 − w)ξb  = w xi σi + (1 − w)σb  . 


 1−w


 σn σo xo − ρ1 en − ρ2 − λn = − σb σn
i=1 i=1 

 w




 m − (1 − w)eb
So Theorem 2 is proved. 

 eo xo = (II)


 w
Proof of Theorem 3 




 xo = 1 (III)
The necessary and sufficient KKT optimality conditions are 




 λ o = 0



 ∂L 1−w 

 x i =0


 = QX + σb σ − ρ1 e − ρ2 1 


 
 λ > 0, i = 1, 2, . . . , n, i , o


 ∂X w i




 − λ1 A1 − λ2 A2 − · · · − λn An = 0,





 T m − (1 − w)eb
e X =


 w
,

 (iii) q = 2. Let the j-th λ and k-th λ equal zero, i.e., λ j = 0,


 1T X = 1,


 λk = 0. The equation set (21) can be transformed into the fol-




 λi ATi X = 0, lowing equation set (23). Since x j + xk = 1, from the con-



 straint (IV) in the equation set (23) we know that the inequation


 ATi X ≥ 0, m − (1 − w)eb


 λ ≥ 0, i = 1, 2, . . . , n, ej ≤ ≤ ek must hold.
i w
13
  
 σ1 σ j σ1 σk −e1 −1
 
B1 =  ..  ,
 . 
σn σ j σn σk −en −1


 1−w


 σ1 σ j x j + σ1 σk xk − ρ1 e1 − ρ2 − λ1 = − σb σ1 B2 = −E,


 w  2 

  σ j σ j σk −e j −1


 1−w  


 σ2 σ j x j + σ2 σk xk − ρ1 e2 − ρ2 − λ2 = − σb σ2 σσ σ2k −ek −1


 w B3 =  k j .



 ..  e j ek 0 0 

 



. 1 1 0 0




 1−w



 σ2j x j + σ j σk xk − ρ1 e j − ρ2 = − σb σ j So C2 can be represented by


 w


 1−w


 σk σ j x j + σ2k xk − ρ1 ek − ρ2 = − σb σk


 w " #


 B1 B2

 .. C2 = .
 . B3 0





 1−w


 σn σ j x j + σn σk xk − ρ1 en − ρ2 − λn = − σb σn According to the statement we made, e j , ek , so B3 is of full

 w


 rank. And we know B2 is also of full rank, so we perform ele-

 m − (1 − w)eb


 e j x j + ek xk = mentary
(IV) row operations on the matrix C2 and get




 w " #




 x + x = 1 0 B−1



j k C−1
2 =
3
−1 .


 λ j = λk = 0 B−1
2 −B−1
2 B1 B3







 xi = 0 Then the solution of the equation set (23) is given by





 x j,k ≥ 0


  1−w 
 λi > 0, i = 1, 2, . . . , n, i , j, i , k  −
   σb σ1 
(23)  j  x 
 w 
 x   1 − w 
  k  − σb σ2 
ρ1   w 
   .. 
Let C2 denote the coefficient matrix of equation set (23). ρ2  = C−1  . 
  2    . (25)
Then λ 
 1 − w 
 1   − σb σn 
 ..   w 
 .   m − (1 − w)eb 
   
λn  w 
  1
 σ1 σ j σ1 σk −e1 −1 −1 0 ... 0 
 σ2 σ j σ2 σk −e2 −1 0 −1 0 ... 0 
 Thus,
 
 ..
 .   
 2   e − m − (1 − w)eb 
 σ j σ j σk −e j −1 0 ··· 0   k 
  w 
C2 =  σk σ j σ2k −ek −1 0 ··· 0  " #  ek − e j 
 ..  xj  
 .  =   .
  xk  m − (1 − w)eb 
 σn σ j −en −1 0 ··· 0 −1 
 σn σk
 − e j 
 e j ek 0 ··· 0   w 
  ek − e j
1 1 0 ··· 0
  So the feasible solution of model (5) is X
 σ1 σ j σ1 σk −e1 −1 −1  =
 .. .. 
 [0 0 · · · x j · · · xk · · · 0 0]T . And if the objective value
 . .
  with this feasible solution is minimum, it is the optimal
 σn σ j σn σk −en −1 ... −1 solution. Hence, one optimal solution of model (5) is
→  σ2 
 j σ j σk −e j −1 0 ... 0  X∗ = [0 0 · · · x j · · · xk · · · 0 0]T .

 σk σ j σ2k −ek −1 0 ... 0  (iv) q ≥ 3. Let Cq denote the coefficient matrix. We perform
 
 e j ek 0 0 0 ... 0  elementary row operations on the augmented matrix of Cq and
1 1 0 0 0 ... 0 find ρ1 = ρ2 = 0. In these situations, not all xi satisfy xi ≥ 0, i =
(24) 1, 2, . . . , n, respectively. So there is no solution to the equation
set (21) when q ≥ 3.
Define the (n − 2) × 4 matrix B1 , the (n − 2) unit matrix B2 To sum up, there is only one optimal solution to model (3),
and 4 × 4 matrix B3 respectively as and the optimal solution is X∗ = [0 0 · · · x j · · · xk · · · 0 0]T
14
where · · · < eh < · · · < e j < · · · < ek < · · · < en .
  Points e1 , . . . , eg , . . . , eh , . . . , e j , . . . , ek , . . . , en divide the inter-
 e − m − (1 − w)eb  eT − (1 − w)eb
 k w  val [e1 , en ] into n − 1 intervals. When belongs
  w
" #  ek − e j  to one of the intervals, model (3) has only one optimal solution.
xj  
=   . Each optimal solution corresponds to a section of efficient fron-
xk  m − (1 − w)eb 
 tier. There is a possibility that the optimal solutions of several
− e j 
 w  adjacent intervals are the same. Therefore, the efficient frontier
ek − e j is composed of at most n − 1 curves.
Proof of Theorem 4
Third, prove that σ2pb is a strictly increasing function of eT for
According to the definition we have given, the efficient fron-
eT ∈ [we1 +(1−w)eb , wen +(1−w)eb ]. In equation (26), it’s clear
tier lies in the stock portfolio variance-total expected return
that σ2pb is a strictly increasing function of eT for eT ∈ [weg +
space. Let eT denote the expected return of total wealth, σ2pb
(1 − w)eb , weh + (1 − w)eb ]. Let m1 denote an arbitrary number
is the variance of stock portfolio.
which belongs to interval [weg + (1 − w)eb , weh + (1 − w)eb ).
First, prove that the efficient frontier is a continuous curve
Then we can get σ2pb (m1 ) < σ2pb (weh + (1 − w)eb ).
composed of different parabolas. Note that e1 < · · · < eg <
· · · < eh < · · · < e j < · · · < ek < · · · < en . According to the
eT − (1 − w)eb Similarly, σ2pb is a strictly increasing function of eT for eT ∈
solving process in the Appendix A2, if eg ≤ ≤ [weh + (1 − w)eb , we j + (1 − w)eb ] in equation (27). Let m2
w
eh , the g-th and the h-th stocks compose a feasible solution, and denote an arbitrary number which belongs to interval (weh +
if this feasible solution makes the objective function minimum, (1 − w)eb , we j + (1 − w)eb ]. Then we get σ2pb (weh + (1 − w)eb ) <
it is a optimal solution. So when model (3) selects the g-th and σ2pb (m2 ).
the h-th stocks, the efficient frontier of the stock portfolio takes
the form: Since eg < eh < e j , we know m1 < m2 . So we get σ2pb (m1 ) <
 2 σ2pb (m2 )
when m1 < m2 . Apparently, σ2pb is a strictly increasing
 (σ − σ ) eT − (1 − w)eb + (e σ − e σ ) 

 h g
w
h g g h 
 function of eT for eT ∈ [weg + (1 − w)eb , we j + (1 − w)eb ].
σ2pb =   (26) Similarly, σ2pb is a strictly increasing function of eT for eT ∈
 eh − eg 
[we1 + (1 − w)eb , wen + (1 − w)eb ].

where eT ∈ [weg + (1 − w)eb , weh + (1 − w)eb ]. Therefore, Theorem 4 is proved.

eT − (1 − w)eb Proof of Theorem 5
As eT increases, < [eg , eh ], e.g.,
w
eT − (1 − w)eb
∈ [eh , e j ], then model (3) selects the h-th Let X∗b denote the optimal solution of model (3). If e j ≤
w m − (1 − w)eb
and the j-th stocks. Thus the efficient frontier takes the form: ≤ ek , according to the solving process in the
w
 2 Appendix A2, the g-th and the h-th stocks compose a fea-
 (σ − σ ) eT − (1 − w)eb + (e σ − e σ )  sible solution, and if this feasible solution makes the objec-
 j h
w
j h h j 

σ2pb =   (27) tive function minimum, it is a optimal solution. So we get
 e j − eh 
X∗b = [0 0 · · · x jb · · · xkb · · · 0 0]T .

where eT ∈ [weh + (1 − w)eb , we j + (1 − w)eb ]. If e j ≤ m ≤ ek , X = [0 0 · · · x j · · · xk · · · 0 0]T is a feasible

We have proved that when eT ∈ [weg + (1 − w)eb , weh + (1 −
w)eb ], the efficient frontier is a part of the parabola described in
equation (26); when eT ∈ [weh + (1 − w)eb , we j + (1 − w)eb ], the
efficient frontier is a part of the parabola described in equation
(27). Meantime, when eT = weh + (1 − w)eb , σ2pb calculated
by equation (26) and equation (27) are the same. So it could
be summed up as follows. When eT ∈ [weg + (1 − w)eb , we j +
(1 − w)eb ], the efficient frontier is a continuous curve that is
composed of the two parabolas.
Similarly, we can get an efficient frontier that is composed of
three parabolas for eT ∈ [weg + (1 − w)eb , wek + (1 − w)eb ]. The
process can go on until eT ∈ [we1 +(1−w)eb , wen +(1−w)eb ], so
the efficient frontier is a continuous curve composed of different
parabolas.
Second, prove that the efficient frontier is composed of
at most n − 1 parabolas. Note that e1 < · · · < eg <
15
solution of model (10). Note that the difference between the
objective functions of model (3) and model (10) is irrelevant of
decision variables. So X is the optimal solution of model (10).
Model (3) and model (10) both select the j − th and the k − th
stocks. Therefore, Theorem 5 is proved.
Proof of Theorem 6
Before proving, we first give a lemma to facilitate the proof.
Since background risk is exogenous and w is pre-fixed, it is easy
to prove the following Lemma.
Lemma 2. The optimal solution of the model (3) is also the
optimal solution of the following model (28) and vice versa.
 sideration of background risk
  n 2


 X  we pb + (1 − w)eb = m = m2 ,



 min   xi σi 






i=1 we know that when m = m2 > eb , we have e pb > m2

 m2 − (1 − w)eb

 sub ject to :


 and e pb = . Let point 4 be the point on the


 X n w
 m − (1 − w)eb  m2 − (1 − w)eb 

 xi ei = (28) solid line whose coordinate is σ2p4 , . Since


 w w

 i=1


 m2 − (1 − w)eb



X n
> m2 , we know σ2p4 > σ2p2 . Please also see


 xi = 1 w


 Figure 6. According to Lemma 2, we know that when m is set


 i=1

 at m2 , the variance of the optimal stock portfolio with consid-
xi ≥ 0, i = 1, 2, . . . , n,
eration of background risk is just the variance of the portfolio
which can be considered as the optimal portfolio selection without background risk on point 4. Then, we get the coordi-
model without background risk when the preset expected value nate of the point on the efficient frontier with background risk,
m − (1 − w)eb when m = m2 to be (σ2p4 , m2 ), and we denote it point 5. Com-
is set at .
w pare point 2 and point 5. Since σ2p4 > σ2p2 , we know that when
Then we prove Theorem 6. m > eb , point 5 is on the right of point 2.
(iii) Let point 3 be any point on the solid line whose posi-
tion is lower than point 1. Denote the coordinate of point 3 by
(σ2p3 , m3 ). Then we know m3 < eb . When m = m3 < eb , we can
m3 − (1 − w)eb
get e pb < m3 and e pb = from the constrain
4
w
we pb + (1 − w)eb = m = m3 .
Expected return of total wealth

2 Let point 6 be the point on the solid line whose coordinate is

m2  m3 − (1 − w)eb  m3 − (1 − w)eb
5
σ2p6 , . Since < m3 , we know
1
w w
2 2
eb σ p6 < σ p3 . Please see Figure 6. According to Lemma 2, we
know that when m is set at m3 , the variance of the optimal stock
7
m3
3
portfolio with consideration of background risk is just the vari-
ance of the portfolio without background risk on point 6. So
(σ2p6 , m3 ) should be on the efficient frontier with background
6

risk, and we denote it by point 7. Compare point 3 and point 7.

Variance of stock portfolio
Figure 6: Efficient frontiers with and without background risk. The dashed
curve shows the efficient frontier with background risk and the solid curve
shows the efficient frontier without background risk.
In Figure 6, solid curve is the efficient frontier without back-
ground risk in the (σ2p , eT ) space. Without consideration of
background risk, we have e p = eT . So the solid curve also
represents a set of (σ2p , e p ).
(i) Let point 1 be the point on the solid line whose coordi-
m − (1 − w)eb
nate is (σ2p1 , eb ). When m = eb , = eb . Then from
w
Lemma 2 we know that when m = eb , the optimal stock port-
folio with background risk is just the optimal portfolio with-
out background risk whose expected return is eb . Thus, when
m = eb , the coordinate of the point on the efficient frontier with
background risk is also (σ2p1 , eb ). That is to say, the efficient
frontier with background risk and that without background risk
intersect at the point where m = eb .
(ii) Let point 2 be any point on the solid line whose position
is higher than point 1. Please see Figure 6. Denote the coordi-
nate of point 2 by (σ2p2 , m2 ). Then we know that m2 > eb . From
the expected return constraint of the optimal portfolio with con-
16
Since σ2p3 > σ2p6 , we know that when m < eb , point 7 is on the
left of point 3.
Since point 5 is any point on the efficient frontier with back-
ground risk when m > eb and point 7 is any point on the effi-
cient frontier with background risk when m < eb , Theorem 6 is
proved.
Proof of Theorem 7
Please also see Figure 6. When m = eb , the two frontiers
intersect at point 1. The standard deviations of the two stock
portfolios selected by model (3) and model (10) are the same,
∆σ = σ pb − σ p = σ p1 − σ p1 = 0, so there is no efficiency
difference between the two models. When m , eb , from Figure
6 we can see ∆σ = σ pb − σ p , 0, so there is an efficiency
difference between the two models when m , eb .
Then we prove that the difference increases with eb de-
creases. According to Theorem 4, the efficient frontier with
background risk is a strictly increasing curve. Similarly, we
can prove that the efficient frontier without background risk is
also a strictly increasing curve. We take m = m2 as an exam-
ple. When m = m2 , the coordinates of point 2, point 4 and
 m2 − (1 − w)eb 
point 5 are (σ2p2 , m2 ), σ2p4 , and (σ2p4 , m2 ), so
w
the efficiency difference ∆σ = σ pb − σ p = σ p4 − σ p2 . If eb de-
m2 − (1 − w)eb
creases, increases, then σ2p4 increases because
w
point 4 lies on a increasing curve, and finally ∆σ = σ p4 − σ p2 Guo, X., Chan, R. H., Wong, W. K., Zhu, L., 2019. Mean-variance, mean-
increases. When m is equal to other values, we can get the same var, mean-cvar models for portfolio selection with background risk. Risk
Management 21, 73–98.
result. So the efficiency difference increases with eb decreases. Guo, X., Wagener, A., Wong, W. K., Zhu, L., 2018. The two-moment decision
Therefore Theorem 7 is proved. model with additive risks. Risk Management 20, 77–94.
Proof of Theorem 8 Hara, C., Huang, J., Kuzmics, C., 2008. Effects of background risks on cau-
From the proof process of Theorem 7, this theorem is easy to tiousness with an application to a portfolio choice problem. Journal of Eco-
nomic Theory 146 (1), 346–358.
reach. Heaton, J., Lucas, D., 2000a. Portfolio choice and asset prices: The importance
Proof of Lemma 1 of entrepreneurial risk. The Journal of Finance 55 (3), 1163–1198.
Since ξ j and ξk are normal uncertain variables, x j ξ j + xk ξk is Heaton, J., Lucas, D., 2000b. Portfolio choice in the presence of background
also a normal uncertain variable, and risk. The Economic Journal 110 (460), 1–26.
Hicks, J., et al., 1979. Causality in Economics. Basic Books.
Huang, X., 2010. Portfolio Analysis: From Probabilistic to Credibilistic and
x j ξ j + xk ξk ∼ N(x j e j + xk ek , x j σ j + xk σk ). Uncertain Approaches. Springer-Verlag,Berlin.
Huang, X., 2011. Mean-risk model for uncertain portfolio selection. Fuzzy Op-
Then we can get timization and Decision Making 10, 71–89.
Huang, X., 2012a. Mean-variance models for portfolio selection subject to ex-
σ2p = (x j σ j + xk σk )2 . perts’ estimations. Expert Systems with Applications 39 (5), 5887–5893.
Huang, X., 2012b. A risk index model for portfolio selection with returns
subject to experts’ estimations. Fuzzy Optimization and Decision Making
Substitute equation (12) into above equation, we get 11 (5), 451–463.
" #2 Huang, X., Di, H., 2016. Uncertain portfolio selection with background risk.
(σk − σ j )m + (ek σ j − e j σk ) Applied Mathematics and Computation 276, 284–296.
σ2p = . (29) Huang, X., Zhao, T., 2014. Mean-chance model for portfolio selection based
ek − e j
on uncertain measure. Insurance Mathematics & Economics 59, 243–250.
We know from equation (29) that Jiang, C., Ma, Y., An, Y., 2010. An analysis of portfolio selection with back-
ground risk. Journal of Banking & Finance 34 (12), 3055–3060.
(σk − σ j )m + (ek σ j − e j σk ) Knight, F. H., 1921. Risk, Uncertainty and Profit. Houghton Mifflin,Boston.
σp = . Lensberg, T., 1999. Investment behavior under knightian uncertainty–an evo-
ek − e j lutionary approach. Journal of Economic Dynamics and Control 23 (9-10),
1587–1604.
And we know from equation (8) that Liu, B., 2007. Uncertainty Theory. Springer-Verlag,Berlin.
Liu, B., 2010. Uncertainty Theory: A Branch of Mathematics for Modeling
m − (1 − w)eb Human Uncertainty. Springer-Verlag,Berlin.
(σk − σ j ) + (ek σ j − e j σk ) Markowitz, H., 1952. Portfolio selection. The Journal of Finance 7 (1), 77–91.
σ pb = w . Tversky, A., Kahneman, D., 1986. Rational choice and the framing of decisions.
ek − e j Journal of Business 59, 251–278.
Yao, K., 2015. A formula to calculate the variance of uncertain variable. Soft
So the efficiency difference is Computing 19, 2947–2953.
Zhai, J., Bai, M., 2018. Mean-risk model for uncertain portfolio selection with
1−w background risk. Journal of Computational & Applied Mathematics 330,
(m − eb )(σk − σ j ) 59–69.
4σ = σ pb − σ p = w . (30)
ek − e j

Therefore, Lemma 1 is proved.

References
Asano, T., 2006. Portfolio inertia under ambiguity. Mathematical Social Sci-
ences 52 (3), 223–232.
Atella, V., Brunetti, M., Maestas, N., 2012. Household portfolio choices, health
status and health care systems: A cross-country analysis based on share.
Journal of Banking & Finance 36 (5), 1320–1335.
Baptista, A. M., 2008. Optimal delegated portfolio management with back-
ground risk. Journal of Banking & Finance 32 (6), 977–985.
Baptista, A. M., 2012. Portfolio selection with mental accounts and background
risk. Journal of Banking & Finance 36 (4), 968–980.
Black, F., Litterman, R., 1992. Global portfolio optimization. Financial Ana-
lysts Journal 48 (5), 28–43.
Campbell, J. Y., 2006. Household finance. The Journal of Finance 61 (4), 1553–
1604.
Cardak, B. A., Wilkins, R., 2009. The determinants of household risky asset
holdings: Australian evidence on background risk and other factors. Journal
of Banking & Finance 33 (5), 850–860.
Cocco, J. F., 2004. Portfolio choice in the presence of housing. The Review of
Financial Studies 18 (2), 535–567.
Eichner, T., Wagener, A., 2009. Multiple risks and mean-variance preferences.
Operations Research 57 (5), 1142–1154.
Gollier, C., 2001. The Economics of Risk and Time. MIT press,Boston.

17