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Abstract: The Effect of Limited Information and Estimation Risk on Optimal Portfolio Diversification


  • Klein, Roger W.
  • Bawa, Vijay S.


This paper analyzes the effect of limited information and estimation risk on optimal portfolio choice when the joint probability distribution of security returns is multivariate normal and the underlying parameters (means and variance-covariance matrix) are unknown. We first consider the case of limited, but sufficient information (the number of observations per security exceeds the number of securities or the prior distribution of the underlying parameters is “sufficiently†informative). We show that for a general family of conjugate priors, the admissible set of portfolios, taking estimation risk into account, may be obtained by the traditional mean-variance analysis. As a result of estimation risk the optimal portfolio choice differs from that obtained by traditional analysis.

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  • Klein, Roger W. & Bawa, Vijay S., 1977. "Abstract: The Effect of Limited Information and Estimation Risk on Optimal Portfolio Diversification," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(4), pages 669-669, November.
  • Handle: RePEc:cup:jfinqa:v:12:y:1977:i:04:p:669-669_02

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    Cited by:

    1. Anton Astakhov & Tomas Havranek & Jiri Novak, 2019. "Firm Size And Stock Returns: A Quantitative Survey," Journal of Economic Surveys, Wiley Blackwell, vol. 33(5), pages 1463-1492, December.
    2. Chung, Richard & Kryzanowski, Lawrence, 2001. "Tests of investor cognizance using earnings forecasts of North American analysts," International Review of Economics & Finance, Elsevier, vol. 10(2), pages 187-204.
    3. Sergio H. Lence & Dermot J. Hayes, 1994. "The Empirical Minimum-Variance Hedge," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 76(1), pages 94-104.
    4. Abdulnasser Hatemi-J & Mohamed Ali Hajji & Youssef El-Khatib, 2019. "Exact Solution for the Portfolio Diversification Problem Based on Maximizing the Risk Adjusted Return," Papers 1903.01082,
    5. Clarkson, Peter M. & Satterly, Amanda, 1997. "Australian evidence on the pricing of estimation risk," Pacific-Basin Finance Journal, Elsevier, vol. 5(3), pages 281-299, July.
    6. Lam, Swee-Sum & Du, Jing, 2004. "Information asymmetry and estimation risk: Preliminary evidence from Chinese equity markets," Pacific-Basin Finance Journal, Elsevier, vol. 12(3), pages 311-331, June.
    7. Hatemi-J, Abdulnasser & El-Khatib, Youssef, 2015. "Portfolio selection: An alternative approach," Economics Letters, Elsevier, vol. 135(C), pages 141-143.
    8. D.J. Johnstone, 2015. "Information and the Cost of Capital in a Mean-Variance Efficient Market," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 42(1-2), pages 79-100, January.
    9. Robert M. Hull & George E. Pinches, 1995. "Firm Size and the Information Content of Over-the-Counter Common Stock Offerings," Journal of Entrepreneurial Finance, Pepperdine University, Graziadio School of Business and Management, vol. 4(1), pages 31-55, Spring.
    10. Rowland K. Atiase & Linda S. Bamber & Senyo Tse, 1989. "Timeliness of financial reporting, the firm size effect, and stock price reactions to annual earnings announcements," Contemporary Accounting Research, John Wiley & Sons, vol. 5(2), pages 526-552, March.
    11. Thierry Post, 2001. "Performance Evaluation in Stochastic Environments Using Mean-Variance Data Envelopment Analysis," Operations Research, INFORMS, vol. 49(2), pages 281-292, April.
    12. Hollstein, Fabian & Prokopczuk, Marcel & Wese Simen, Chardin, 2020. "Beta uncertainty," Journal of Banking & Finance, Elsevier, vol. 116(C).
    13. Steven A. Dennis & Ian G. Sharpe, 2005. "Firm Size Dependence in the Determinants of Bank Term Loan Maturity," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 32(1-2), pages 31-64.
    14. Mark Grinblatt & Juhani T. Linnainmaa, 2011. "Jensen's Inequality, Parameter Uncertainty, and Multi-period Investment," Review of Asset Pricing Studies, Oxford University Press, vol. 1(1), pages 1-34.
    15. Frankfurter, George M. & Phillips, Herbert E., 1996. "Normative implications of equilibrium models: Homogeneous expectations and other artificialities," Journal of Economic Behavior & Organization, Elsevier, vol. 31(1), pages 67-83, October.
    16. Stambaugh, Robert F., 1997. "Analyzing investments whose histories differ in length," Journal of Financial Economics, Elsevier, vol. 45(3), pages 285-331, September.
    17. David Aboody & Mary E. Barth & Ron Kasznik, 2004. "Firms' Voluntary Recognition of Stock‐Based Compensation Expense," Journal of Accounting Research, Wiley Blackwell, vol. 42(2), pages 123-150, May.
    18. David D Cho, 2011. "Estimation risk in covariance," Journal of Asset Management, Palgrave Macmillan, vol. 12(4), pages 248-259, September.
    19. Celso Brunetti & Jeffrey H. Harris & Shawn Mankad, 2018. "Bank Holdings and Systemic Risk," Finance and Economics Discussion Series 2018-063, Board of Governors of the Federal Reserve System (U.S.).
    20. George M. Frankfurter & Christopher G. Lamoureux, 1989. "Estimation And Selection Bias In Mean-Variance Portfolio Selection," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 12(2), pages 173-181, June.
    21. Steven A. Dennis & Ian G. Sharpe, 2005. "Firm Size Dependence in the Determinants of Bank Term Loan Maturity," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 32(1‐2), pages 31-64, January.
    22. Shane A. Corwin & Jay F. Coughenour, 2008. "Limited Attention and the Allocation of Effort in Securities Trading," Journal of Finance, American Finance Association, vol. 63(6), pages 3031-3067, December.
    23. Albert Eddy & Bruce Seifert, 1988. "Firm Size And Dividend Announcements," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 11(4), pages 295-302, December.

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