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Incorporating estimation risk in portfolio choice

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Author Info
Horst, J.R. ter
Roon, F.A. de
Werker, B.J.M. (Tilburg University, Center for Economic Research)

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Abstract

We propose an adjustment in mean-variance portfolio weights to incorporate uncertainty caused by the fact that, in general, we have to use estimated expected returns. The adjustment amounts to using a higher pseudo risk-aversion rather than the actual risk-aversion. The difference between the actual and the pseudo risk-aversion depends on the sample size, the number of assets in the portfolio, and the curvature of the mean-variance frontier. Applying the adjustment to international portfolios, we show that the adjustments are nontrivial for G5 country portfolios and that they are even more important when emerging markets are included. We also show that, in the case of time-varying expected country returns, our adjustment implies a signifficantly smaller variability in portfolio weights than is commonly believed.

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Paper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 65.

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Date of creation: 2000
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Handle: RePEc:dgr:kubcen:200065

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Find related papers by JEL classification:
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

  1. Jorion, Philippe, 1985. "International Portfolio Diversification with Estimation Risk," Journal of Business, University of Chicago Press, vol. 58(3), pages 259-78, July. [Downloadable!] (restricted)
  2. Wayne E. Ferson & Campbell R. Harvey, 1999. "Conditioning Variables and the Cross-Section of Stock Returns," NBER Working Papers 7009, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  3. Jorion, Philippe, 1991. "Bayesian and CAPM estimators of the means: Implications for portfolio selection," Journal of Banking & Finance, Elsevier, vol. 15(3), pages 717-727, June. [Downloadable!] (restricted)
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  1. Piti Disyatat & Gaston R. Gelos, 2001. "The Asset Allocation of Emerging Market Mutual Funds," IMF Working Papers 01/111, International Monetary Fund. [Downloadable!]
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This page was last updated on 2009-11-25.

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