IDEAS home Printed from https://ideas.repec.org/p/hhs/lunewp/2003_017.html
   My bibliography  Save this paper

The Impact of Estimation Error on Portfolio Selection for Investors with Constant Relative Risk Aversion

Author

Listed:
  • Bengtsson, Christoffer

    (Department of Economics, Lund University)

Abstract

This paper examines the impact of estimation error in a simple single-period portfolio choice problem when the investor has power utility and asset returns are jointly lognormally distributed. These assumptions imply that such an investor selects portfolios using a modified mean-variance framework where the parameters that he has to estimate are the mean vector of log returns and the covariance matrix of log returns. Following Chopra and Ziemba (1993), I simulate estimation error in what are assumed to be the true mean vector and the true covariance matrix and the impact of estimation error is measured in terms of percentage cash equivalence loss for the investor. To obtain estimation error sizes that are similar to the estimation error sizes in actual estimates, I use a Bayesian approach and Markov Chain Monte Carlo Methods. The empirical results differ significantly from Chopra and Ziemba (1993), suggesting that the effect of estimation error may have been overestimated in the past. Furthermore, the results tend to question the traditional viewpoint that estimating the covariance matrix correctly is strictly less important than estimating the mean vector correctly.

Suggested Citation

  • Bengtsson, Christoffer, 2003. "The Impact of Estimation Error on Portfolio Selection for Investors with Constant Relative Risk Aversion," Working Papers 2003:17, Lund University, Department of Economics, revised 29 Apr 2004.
  • Handle: RePEc:hhs:lunewp:2003_017
    as

    Download full text from publisher

    File URL: http://project.nek.lu.se/publications/workpap/Papers/WP03_17.pdf
    Download Restriction: no

    References listed on IDEAS

    as
    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    2. 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.
    3. Ohlson, J. A. & Ziemba, W. T., 1976. "Portfolio Selection in a Lognormal Market When the Investor Has a Power Utility Function," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 11(01), pages 57-71, March.
    4. Ledoit, Olivier & Wolf, Michael, 2003. "Improved estimation of the covariance matrix of stock returns with an application to portfolio selection," Journal of Empirical Finance, Elsevier, vol. 10(5), pages 603-621, December.
    5. Best, Michael J & Grauer, Robert R, 1991. "On the Sensitivity of Mean-Variance-Efficient Portfolios to Changes in Asset Means: Some Analytical and Computational Results," Review of Financial Studies, Society for Financial Studies, vol. 4(2), pages 315-342.
    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. repec:wsi:afexxx:v:09:y:2014:i:02:n:s2010495214400016 is not listed on IDEAS
    2. A. D. Hall & S. E. Satchell & P. J. Spence, 2015. "Evaluating the impact of inequality constraints and parameter uncertainty on optimal portfolio choice," Applied Economics, Taylor & Francis Journals, vol. 47(45), pages 4801-4813, September.

    More about this item

    Keywords

    Portfolio selection; Estimation risk; Markov Chain Monte Carlo;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

    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:hhs:lunewp:2003_017. 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: (David Edgerton). General contact details of provider: http://edirc.repec.org/data/delunse.html .

    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 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.

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

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.