Incorporating Economic Objectives into Bayesian Priors: Portfolio Choice Under Parameter Uncertainty

Abstract:     
Economic objectives are often ignored when estimating parameters, though the loss of doing so can be substantial. This paper proposes a way to allow Bayesian priors to reflect the objectives. Using monthly returns of the Fama-French 25 size and book-to-market portfolios and their three factors from January 1965 to December 2004, we find that investment performance under the objective-based priors can be significantly different from that under alternative priors, with differences in terms of annual certainty-equivalent returns greater than 10% in many cases. In terms of out-of-sample performance, the Bayesian rules under the objective-based priors can outperform substantially some of the best rules developed in the classical framework.

Keywords: Portfolio choice, Parameter uncertainty, Bayesian priors

JEL Classifications: G11, G12, C11

Working Paper Series