Reducing Estimation Risk in Optimal Portfolio Selection When Short Sales are Allowed
Managerial and Decision Economics, Vol. 30, No. 5, pp. 281-305, July 2009
Posted: 5 Sep 2008 Last revised: 30 Jun 2009
The issue of estimation risk is of particular interest to the decision-making processes of portfolio managers who use long-short investment strategies. Accordingly, our paper explores the question of whether a VaR constraint reduces estimation risk when short sales are allowed. We find that such a constraint notably decreases errors in estimates of the expected return, standard deviation, and VaR of optimal portfolios. Furthermore, optimal portfolios in the presence of the constraint are substantially closer to the 'true' efficient frontier than those in its absence. Finally, we provide VaR bounds and confidence levels for the constraint that lead to the best out-of-sample performance.
Keywords: Estimation Risk, Portfolio Selection, Short Sales, VaR, Risk Management
JEL Classification: G11, G12, D81
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