IDEAS home Printed from https://ideas.repec.org/p/cte/wsrepe/ws132119.html
   My bibliography  Save this paper

Parameter uncertainty in multiperiod portfolio optimization with transaction costs

Author

Listed:
  • Miguel, Victor de
  • Martín Utrera, Alberto
  • Nogales, Francisco J.

Abstract

We study the impact of parameter uncertainty in multiperiod portfolio selection with trading costs. We analytically characterize the expected loss of a multiperiod investor, and we find that it is equal to the product of two terms. The first term corresponds with the single-period utility loss in the absence of transaction costs, as characterized by Kan and Zhou (2007), whereas the second term captures the multiperiod effects on the overall utility loss. To mitigate the impact of parameter uncertainty, we propose two multiperiod shrinkage portfolios. The first multiperiod shrinkage portfolio combines the Markowitz portfolio with a target portfolio. This method diversifies the effects of parameter uncertainty and reduces the risk of taking inefficient positions. The second multiperiod portfolio shrinks the investor's trading rate. This novel technique smooths the investor trading activity and it also may help to considerably reduce the impact of parameter uncertainty. Finally, we test the out-of-sample performance of our considered portfolio strategies with simulated and empirical datasets, and we find that ignoring transaction costs, parameter uncertainty, or both, results into large losses in the investor's performance

Suggested Citation

  • Miguel, Victor de & Martín Utrera, Alberto & Nogales, Francisco J., 2013. "Parameter uncertainty in multiperiod portfolio optimization with transaction costs," DES - Working Papers. Statistics and Econometrics. WS ws132119, Universidad Carlos III de Madrid. Departamento de Estadística.
    • Handle: RePEc:cte:wsrepe:ws132119
    as

    Download full text from publisher

    File URL: https://e-archivo.uc3m.es/bitstream/handle/10016/17143/ws132119.pdf?sequence=1
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. DeMiguel, Victor & Martin-Utrera, Alberto & Nogales, Francisco J., 2013. "Size matters: Optimal calibration of shrinkage estimators for portfolio selection," Journal of Banking & Finance, Elsevier, vol. 37(8), pages 3018-3034.
    2. Ledoit, Olivier & Wolf, Michael, 2004. "A well-conditioned estimator for large-dimensional covariance matrices," Journal of Multivariate Analysis, Elsevier, vol. 88(2), pages 365-411, February.
    3. Tu, Jun & Zhou, Guofu, 2011. "Markowitz meets Talmud: A combination of sophisticated and naive diversification strategies," Journal of Financial Economics, Elsevier, vol. 99(1), pages 204-215, January.
    4. Zhenyu Wang, 2005. "A Shrinkage Approach to Model Uncertainty and Asset Allocation," The Review of Financial Studies, Society for Financial Studies, vol. 18(2), pages 673-705.
    5. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, March.
    6. George M. Constantinides, 1979. "Multiperiod Consumption and Investment Behavior with Convex Transactions Costs," Management Science, INFORMS, vol. 25(11), pages 1127-1137, November.
    7. Fabrizio Lillo & J. Doyne Farmer & Rosario N. Mantegna, 2003. "Master curve for price-impact function," Nature, Nature, vol. 421(6919), pages 129-130, January.
    8. Lorenzo Garlappi & Raman Uppal & Tan Wang, 2007. "Portfolio Selection with Parameter and Model Uncertainty: A Multi-Prior Approach," The Review of Financial Studies, Society for Financial Studies, vol. 20(1), pages 41-81, January.
    9. Ledoit, Oliver & Wolf, Michael, 2008. "Robust performance hypothesis testing with the Sharpe ratio," Journal of Empirical Finance, Elsevier, vol. 15(5), pages 850-859, December.
    10. Klein, Roger W. & Bawa, Vijay S., 1976. "The effect of estimation risk on optimal portfolio choice," Journal of Financial Economics, Elsevier, vol. 3(3), pages 215-231, June.
    11. MacKinlay, A Craig & Pastor, Lubos, 2000. "Asset Pricing Models: Implications for Expected Returns and Portfolio Selection," The Review of Financial Studies, Society for Financial Studies, vol. 13(4), pages 883-916.
    12. Ravi Jagannathan & Tongshu Ma, 2003. "Risk Reduction in Large Portfolios: Why Imposing the Wrong Constraints Helps," Journal of Finance, American Finance Association, vol. 58(4), pages 1651-1683, August.
    13. R.H. Tütüncü & M. Koenig, 2004. "Robust Asset Allocation," Annals of Operations Research, Springer, vol. 132(1), pages 157-187, November.
    14. Ľuboš Pástor, 2000. "Portfolio Selection and Asset Pricing Models," Journal of Finance, American Finance Association, vol. 55(1), pages 179-223, February.
    15. Hong Liu, 2004. "Optimal Consumption and Investment with Transaction Costs and Multiple Risky Assets," Journal of Finance, American Finance Association, vol. 59(1), pages 289-338, February.
    16. Kan, Raymond & Zhou, Guofu, 2007. "Optimal Portfolio Choice with Parameter Uncertainty," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 42(3), pages 621-656, September.
    17. Victor DeMiguel & Lorenzo Garlappi & Francisco J. Nogales & Raman Uppal, 2009. "A Generalized Approach to Portfolio Optimization: Improving Performance by Constraining Portfolio Norms," Management Science, INFORMS, vol. 55(5), pages 798-812, May.
    18. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-1335, November.
    19. Ravi Jagannathan & Tongshu Ma, 2003. "Risk Reduction in Large Portfolios: Why Imposing the Wrong Constraints Helps," Journal of Finance, American Finance Association, vol. 58(4), pages 1651-1684, August.
    20. Greenwood, Robin, 2005. "Short- and long-term demand curves for stocks: theory and evidence on the dynamics of arbitrage," Journal of Financial Economics, Elsevier, vol. 75(3), pages 607-649, March.
    21. M. H. A. Davis & A. R. Norman, 1990. "Portfolio Selection with Transaction Costs," Mathematics of Operations Research, INFORMS, vol. 15(4), pages 676-713, November.
    22. Best, Michael J. & Grauer, Robert R., 1992. "Positively Weighted Minimum-Variance Portfolios and the Structure of Asset Expected Returns," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 27(4), pages 513-537, December.
    23. Rustem, Berc & Becker, Robin G. & Marty, Wolfgang, 2000. "Robust min-max portfolio strategies for rival forecast and risk scenarios," Journal of Economic Dynamics and Control, Elsevier, vol. 24(11-12), pages 1591-1621, October.
    24. D. Goldfarb & G. Iyengar, 2003. "Robust Portfolio Selection Problems," Mathematics of Operations Research, INFORMS, vol. 28(1), pages 1-38, February.
    25. Hong Liu & Mark Loewenstein, 2002. "Optimal Portfolio Selection with Transaction Costs and Finite Horizons," The Review of Financial Studies, Society for Financial Studies, vol. 15(3), pages 805-835.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Moorman, Theodore, 2014. "An empirical investigation of methods to reduce transaction costs," Journal of Empirical Finance, Elsevier, vol. 29(C), pages 230-246.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. DeMiguel, Victor & Martin-Utrera, Alberto & Nogales, Francisco J., 2013. "Size matters: Optimal calibration of shrinkage estimators for portfolio selection," Journal of Banking & Finance, Elsevier, vol. 37(8), pages 3018-3034.
    2. Hwang, Inchang & Xu, Simon & In, Francis, 2018. "Naive versus optimal diversification: Tail risk and performance," European Journal of Operational Research, Elsevier, vol. 265(1), pages 372-388.
    3. Behr, Patrick & Guettler, Andre & Truebenbach, Fabian, 2012. "Using industry momentum to improve portfolio performance," Journal of Banking & Finance, Elsevier, vol. 36(5), pages 1414-1423.
    4. Chakrabarti, Deepayan, 2021. "Parameter-free robust optimization for the maximum-Sharpe portfolio problem," European Journal of Operational Research, Elsevier, vol. 293(1), pages 388-399.
    5. Maillet, Bertrand & Tokpavi, Sessi & Vaucher, Benoit, 2015. "Global minimum variance portfolio optimisation under some model risk: A robust regression-based approach," European Journal of Operational Research, Elsevier, vol. 244(1), pages 289-299.
    6. Han, Chulwoo, 2020. "A nonparametric approach to portfolio shrinkage," Journal of Banking & Finance, Elsevier, vol. 120(C).
    7. Yan, Cheng & Zhang, Huazhu, 2017. "Mean-variance versus naïve diversification: The role of mispricing," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 48(C), pages 61-81.
    8. Fletcher, Jonathan, 2011. "Do optimal diversification strategies outperform the 1/N strategy in U.K. stock returns?," International Review of Financial Analysis, Elsevier, vol. 20(5), pages 375-385.
    9. Füss, Roland & Miebs, Felix & Trübenbach, Fabian, 2014. "A jackknife-type estimator for portfolio revision," Journal of Banking & Finance, Elsevier, vol. 43(C), pages 14-28.
    10. Hautsch, Nikolaus & Voigt, Stefan, 2019. "Large-scale portfolio allocation under transaction costs and model uncertainty," Journal of Econometrics, Elsevier, vol. 212(1), pages 221-240.
    11. Moorman, Theodore, 2014. "An empirical investigation of methods to reduce transaction costs," Journal of Empirical Finance, Elsevier, vol. 29(C), pages 230-246.
    12. Joo, Young C. & Park, Sung Y., 2021. "Optimal portfolio selection using a simple double-shrinkage selection rule," Finance Research Letters, Elsevier, vol. 43(C).
    13. Vasyl Golosnoy, 2010. "No-transaction bounds and estimation risk," Quantitative Finance, Taylor & Francis Journals, vol. 10(5), pages 487-493.
    14. Hsu, Po-Hsuan & Han, Qiheng & Wu, Wensheng & Cao, Zhiguang, 2018. "Asset allocation strategies, data snooping, and the 1 / N rule," Journal of Banking & Finance, Elsevier, vol. 97(C), pages 257-269.
    15. Kourtis, Apostolos & Dotsis, George & Markellos, Raphael N., 2012. "Parameter uncertainty in portfolio selection: Shrinking the inverse covariance matrix," Journal of Banking & Finance, Elsevier, vol. 36(9), pages 2522-2531.
    16. Cheng Yan & Ji Yan, 2021. "Optimal and naive diversification in an emerging market: Evidence from China's A‐shares market," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 26(3), pages 3740-3758, July.
    17. Johannes Bock, 2018. "An updated review of (sub-)optimal diversification models," Papers 1811.08255, arXiv.org.
    18. Caner, Mehmet & Medeiros, Marcelo & Vasconcelos, Gabriel F.R., 2023. "Sharpe Ratio analysis in high dimensions: Residual-based nodewise regression in factor models," Journal of Econometrics, Elsevier, vol. 235(2), pages 393-417.
    19. Loriana Pelizzon & Massimiliano Caporin, 2012. "Market volatility, optimal portfolios and naive asset allocations," Working Papers 2012_08, Department of Economics, University of Venice "Ca' Foscari".
    20. Olivier Ledoit & Michael Wolf, 2014. "Nonlinear shrinkage of the covariance matrix for portfolio selection: Markowitz meets Goldilocks," ECON - Working Papers 137, Department of Economics - University of Zurich, revised Feb 2017.

    More about this item

    Keywords

    Estimation error;

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:cte:wsrepe:ws132119. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Ana Poveda (email available below). General contact details of provider: http://portal.uc3m.es/portal/page/portal/dpto_estadistica .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.