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Incorporating Estimation Risk in Portfolio Choice

Author

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  • Ter Horst, J.R.

    (Tilburg University, Center For Economic Research)

  • de Roon, F.A.

    (Tilburg University, Center For Economic Research)

  • Werker, B.J.M.

    (Tilburg University, Center For Economic Research)

Abstract

We propose an adjustment in mean-variance portfolio weights to incorporate uncertainty caused by the fact that, in general, we have to use estimated expected returns.The adjustment amounts to using a higher pseudo risk-aversion rather than the actual risk-aversion.The difference between the actual and the pseudo risk-aversion depends on the sample size, the number of assets in the portfolio, and the curvature of the mean-variance frontier.Applying the adjustment to international portfolios, we show that the adjustments are nontrivial for G5 country portfolios and that they are even more important when emerging markets are included.We also show that, in the case of time-varying expected country returns, our adjustment implies a signifficantly smaller variability in portfolio weights than is commonly believed.

Suggested Citation

  • Ter Horst, J.R. & de Roon, F.A. & Werker, B.J.M., 2000. "Incorporating Estimation Risk in Portfolio Choice," Discussion Paper 2000-65, Tilburg University, Center for Economic Research.
  • Handle: RePEc:tiu:tiucen:30107fbe-2dc9-43d5-a086-efa7f412be10
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    File URL: https://pure.uvt.nl/ws/portalfiles/portal/536133/65.pdf
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    References listed on IDEAS

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    1. Wayne E. Ferson & Campbell R. Harvey, 1999. "Conditioning Variables and the Cross Section of Stock Returns," Journal of Finance, American Finance Association, vol. 54(4), pages 1325-1360, August.
    2. De Santis, Giorgio & Gerard, Bruno, 1997. " International Asset Pricing and Portfolio Diversification with Time-Varying Risk," Journal of Finance, American Finance Association, vol. 52(5), pages 1881-1912, December.
    3. Harvey, Campbell R, 1995. "Predictable Risk and Returns in Emerging Markets," Review of Financial Studies, Society for Financial Studies, vol. 8(3), pages 773-816.
    4. Barry, Christopher B, 1974. "Portfolio Analysis under Uncertain Means, Variances, and Covariances," Journal of Finance, American Finance Association, vol. 29(2), pages 515-522, May.
    5. Dybvig, Philip H, 1984. " Short Sales Restrictions and Kinks on the Mean Variance Frontier," Journal of Finance, American Finance Association, vol. 39(1), pages 239-244, March.
    6. Bekaert, Geert & Harvey, Campbell R., 1997. "Emerging equity market volatility," Journal of Financial Economics, Elsevier, vol. 43(1), pages 29-77, January.
    7. Jorion, Philippe, 1985. "International Portfolio Diversification with Estimation Risk," The Journal of Business, University of Chicago Press, vol. 58(3), pages 259-278, July.
    8. Jorion, Philippe, 1986. "Bayes-Stein Estimation for Portfolio Analysis," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 21(3), pages 279-292, September.
    9. Jorion, Philippe, 1991. "Bayesian and CAPM estimators of the means: Implications for portfolio selection," Journal of Banking & Finance, Elsevier, vol. 15(3), pages 717-727, June.
    10. Chen, Son-Nan & Brown, Stephen J, 1983. " Estimation Risk and Simple Rules for Optimal Portfolio Selection," Journal of Finance, American Finance Association, vol. 38(4), pages 1087-1093, September.
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    Cited by:

    1. Piti Disyatat & R. G Gelos, 2001. "The Asset Allocation of Emerging Market Mutual Funds," IMF Working Papers 01/111, International Monetary Fund.
    2. C├ędric Perret-Gentil & Maria-Pia Victoria-Feser, 2005. "Robust Mean-Variance Portfolio Selection," FAME Research Paper Series rp140, International Center for Financial Asset Management and Engineering.

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