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Universal Portfolio Shrinkage

Author

Listed:
  • Bryan T. Kelly
  • Semyon Malamud
  • Mohammad Pourmohammadi
  • Fabio Trojani

Abstract

We introduce a novel shrinkage methodology for building optimal portfolios in environments of high complexity, where the number of assets is comparable to or larger than the number of observations. Our universal portfolio shrinkage approximator (UPSA) is given in closed form, is easy to implement, and improves upon existing shrinkage methods. It exhibits an explicit two-fund separation, complementing the Markowitz portfolio with an optimal complexity correction. UPSA does not annihilate the low-variance principal components (PCs) of returns; instead, it optimally reweighs them and produces a stochastic discount factor that substantially improves on its feasible PC-sparse counterparts.

Suggested Citation

  • Bryan T. Kelly & Semyon Malamud & Mohammad Pourmohammadi & Fabio Trojani, 2023. "Universal Portfolio Shrinkage," NBER Working Papers 32004, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:32004
    Note: AP
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    JEL classification:

    • C1 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General
    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • C55 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Large Data Sets: Modeling and Analysis
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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