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Uncertainty in Second Moments: Implications for Portfolio Allocation

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  • David Daewhan Cho
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    Abstract

    This paper investigates the uncertainty in variance and covariance of asset returns. It is commonly believed that these second moments can be estimated very accurately. However, time varying volatility and nonnormality of asset returns can lead to imprecise variance estimates. Using CRSP value weighted monthly returns from 1926 to 2001, this paper shows that the variance is less accurately estimated than the expected return. In addition, a mean variance investor will incur significant certainty equivalent loss due to the uncertainty in second moments. Applying the Fama French 3 factor model to 25 size, BE/ME sorted portfolios from 1963 to 2001, the loss due to the variance estimation can be shown to be as large as the loss due to the expected return estimation. Moreover, as the number of assets in the portfolio increases, the loss due to the variance uncertainty becomes larger. This provides a possible explanation to the home bias puzzle.

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    Bibliographic Info

    Paper provided by Econometric Society in its series Econometric Society 2004 Far Eastern Meetings with number 433.

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    Date of creation: 11 Aug 2004
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    Handle: RePEc:ecm:feam04:433

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    Related research

    Keywords: estimation risk; time varying volatility; bayesian analysis; kurtosis;

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    1. Bai, Xuezheng & Russell, Jeffrey R. & Tiao, George C., 2003. "Kurtosis of GARCH and stochastic volatility models with non-normal innovations," Journal of Econometrics, Elsevier, vol. 114(2), pages 349-360, June.
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    3. Engle, Robert F, 1982. "Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of United Kingdom Inflation," Econometrica, Econometric Society, vol. 50(4), pages 987-1007, July.
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