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Risk Reduction in Large Portfolios: Why Imposing the Wrong Constraints Helps

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  • Ravi Jagannathan
  • Tongshu Ma

Abstract

Green and Hollifield (1992) argue that the presence of a dominant factor would result in extreme negative weights in mean‐variance efficient portfolios even in the absence of estimation errors. In that case, imposing no‐short‐sale constraints should hurt, whereas empirical evidence is often to the contrary. We reconcile this apparent contradiction. We explain why constraining portfolio weights to be nonnegative can reduce the risk in estimated optimal portfolios even when the constraints are wrong. Surprisingly, with no‐short‐sale constraints in place, the sample covariance matrix performs as well as covariance matrix estimates based on factor models, shrinkage estimators, and daily data.

Suggested Citation

  • Ravi Jagannathan & Tongshu Ma, 2003. "Risk Reduction in Large Portfolios: Why Imposing the Wrong Constraints Helps," Journal of Finance, American Finance Association, vol. 58(4), pages 1651-1683, August.
  • Handle: RePEc:bla:jfinan:v:58:y:2003:i:4:p:1651-1683
    DOI: 10.1111/1540-6261.00580
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    More about this item

    JEL classification:

    • C49 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Other
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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