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Using Economic Theory to Build Optimal Portfolios

39 Pages Posted: 30 Apr 2008  

Thomas Chevrier

University of Chicago - Booth School of Business

Robert E. McCulloch

University of Chicago - Booth School of Business

Date Written: April 24, 2008

Abstract

Given expected returns and return covariances, portfolio weights are known in closed form in a mean-variance framework. The real difficulty is in estimating these parameters. Using recent advances in Bayesian techniques, we show how investors can incorporate any prior information for optimal portfolio selection. We apply our method to 27 domestic and international data sets. We find that our tangency portfolios have three essential and attractive features. i) They perform better in terms of out-of-sample Sharpe ratio. ii) Their weights are guaranteed to be economically "reasonable": positive, stable, and without extravagant position in any asset. iii) Turnover is very low.

JEL Classification: C11, C13, C15, G11, G12

Suggested Citation

Chevrier, Thomas and McCulloch, Robert E., Using Economic Theory to Build Optimal Portfolios (April 24, 2008). Available at SSRN: https://ssrn.com/abstract=1126596 or http://dx.doi.org/10.2139/ssrn.1126596

Thomas Chevrier (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

Robert E. McCulloch

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

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