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Hierarchical Bayes Methods for Multifactor Model Estimation and Portfolio Selection

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  • Martin R. Young

    (University of Michigan School of Business, Department of Statistics and Management Science, Ann Arbor, Michigan 48109-1234)

  • Peter J. Lenk

    (University of Michigan School of Business, Department of Statistics and Management Science, Ann Arbor, Michigan 48109-1234)

Abstract

The factor model is an important construct for both portfolio managers and researchers in modern finance. For practitioners, factor model coefficients are used to guide the construction of optimal portfolios. For academicians, factor model parameters play a fundamental role in explaining equilibrium asset prices and other market phenomena. This paper presents a hierarchical modeling procedure that can substantially improve the accuracy of factor model parameter estimates through incorporation of cross-sectional information. It is shown that this improvement in parameter estimation accuracy translates into substantial improvement in portfolio performance. Expressions are derived that characterize the sensitivity of portfolio performance to parameter estimation error. Evidence with NYSE data suggests that the hierarchical estimation technique leads to superior out-of-sample portfolio performance when compared to alternative estimation approaches.

Suggested Citation

  • Martin R. Young & Peter J. Lenk, 1998. "Hierarchical Bayes Methods for Multifactor Model Estimation and Portfolio Selection," Management Science, INFORMS, vol. 44(11-Part-2), pages 111-124, November.
    • Handle: RePEc:inm:ormnsc:v:44:y:1998:i:11-part-2:p:s111-s124
    DOI: 10.1287/mnsc.44.11.S111
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    References listed on IDEAS

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    Cited by:

    1. Radu Tunaru, 2015. "Model Risk in Financial Markets:From Financial Engineering to Risk Management," World Scientific Books, World Scientific Publishing Co. Pte. Ltd., number 9524, December.
    2. Vasyl Golosnoy, 2010. "No-transaction bounds and estimation risk," Quantitative Finance, Taylor & Francis Journals, vol. 10(5), pages 487-493.
    3. Golosnoy, Vasyl & Okhrin, Yarema, 2009. "Flexible shrinkage in portfolio selection," Journal of Economic Dynamics and Control, Elsevier, vol. 33(2), pages 317-328, February.

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