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Estimation error in mean returns and the mean-variance efficient frontier

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  • Simaan, Majeed
  • Simaan, Yusif
  • Tang, Yi

Abstract

In this paper, we build estimation error in mean returns into the mean-variance (MV) portfolio theory under the assumption that returns on individual assets follow a joint normal distribution. We derive the conditional sampling distribution of the MV portfolio along with its mean and risk return when the sample covariance matrix is equal to the population covariance matrix. We use the mean squared error (MSE) to characterize the effects of estimation error in mean returns on the joint sampling distributions and examine how such error affects the risk-return tradeoff of the MV portfolios. We show that the negative effects of error in mean returns on the joint sampling distributions increase with the decision maker's risk tolerance and the number of assets in a portfolio, but decrease with the sample size.

Suggested Citation

  • Simaan, Majeed & Simaan, Yusif & Tang, Yi, 2018. "Estimation error in mean returns and the mean-variance efficient frontier," International Review of Economics & Finance, Elsevier, vol. 56(C), pages 109-124.
    • Handle: RePEc:eee:reveco:v:56:y:2018:i:c:p:109-124
    DOI: 10.1016/j.iref.2017.10.019
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    Cited by:

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    2. Taras Bodnar & Holger Dette & Nestor Parolya & Erik Thors'en, 2019. "Sampling Distributions of Optimal Portfolio Weights and Characteristics in Low and Large Dimensions," Papers 1908.04243, arXiv.org, revised Apr 2023.
    3. Taras Bodnar & Solomiia Dmytriv & Yarema Okhrin & Nestor Parolya & Wolfgang Schmid, 2020. "Statistical inference for the EU portfolio in high dimensions," Papers 2005.04761, arXiv.org.
    4. Andrea Rigamonti & Alex Weissensteiner, 2020. "Asset allocation under predictability and parameter uncertainty using LASSO," Computational Management Science, Springer, vol. 17(2), pages 179-201, June.

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    More about this item

    Keywords

    Portfolio theory; Investment; Estimation error; Multivariate analysis;
    All these keywords.

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C44 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Operations Research; Statistical Decision Theory
    • C46 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Specific Distributions
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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