Mean--variance portfolio optimization when means and covariances are unknown
Markowitz's celebrated mean--variance portfolio optimization theory assumes that the means and covariances of the underlying asset returns are known. In practice, they are unknown and have to be estimated from historical data. Plugging the estimates into the efficient frontier that assumes known parameters has led to portfolios that may perform poorly and have counter-intuitive asset allocation weights; this has been referred to as the "Markowitz optimization enigma." After reviewing different approaches in the literature to address these difficulties, we explain the root cause of the enigma and propose a new approach to resolve it. Not only is the new approach shown to provide substantial improvements over previous methods, but it also allows flexible modeling to incorporate dynamic features and fundamental analysis of the training sample of historical data, as illustrated in simulation and empirical studies.
|Date of creation:||Aug 2011|
|Date of revision:|
|Publication status:||Published in Annals of Applied Statistics 2011, Vol. 5, No. 2A, 798-823|
|Contact details of provider:|| Web page: http://arxiv.org/|
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.:
- Isabelle Huault & V. Perret & S. Charreire-Petit, 2007. "Management," Post-Print halshs-00337676, HAL.
- Fan, Jianqing & Fan, Yingying & Lv, Jinchi, 2008. "High dimensional covariance matrix estimation using a factor model," Journal of Econometrics, Elsevier, vol. 147(1), pages 186-197, November.
- Yusif Simaan, 1997. "Estimation Risk in Portfolio Selection: The Mean Variance Model Versus the Mean Absolute Deviation Model," Management Science, INFORMS, vol. 43(10), pages 1437-1446, October.
- Niko Canner & N. Gregory Mankiw & David N. Weil, 1994.
"An Asset Allocation Puzzle,"
NBER Working Papers
4857, National Bureau of Economic Research, Inc.
- Mark Britten-Jones, 1999. "The Sampling Error in Estimates of Mean-Variance Efficient Portfolio Weights," Journal of Finance, American Finance Association, vol. 54(2), pages 655-671, 04.
When requesting a correction, please mention this item's handle: RePEc:arx:papers:1108.0996. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (arXiv administrators)
If references are entirely missing, you can add them using this form.