Cross-Validation Based Covariance Shrinkage in Portfolio Selection

Abstract

In this paper we investigate the applied performance of covariance shrinkage in the portfolio optimisation problem. We suggest that the optimal shrinkage coefficient should be obtained from a numerical optimisation of a function with financial interpretation. Such a function could be the minimisation of the standard deviation of the portfolio returns or the maximisation of the Sharpe Ratio of the portfolio. Empirical evidence indicates that this methodology results in portfolios with better risk/return characteristics.

Keywords: Covariance Matrix, Shrinkage Methods, Portfolio Optimisation