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

See all articles by Gordon J. Alexander

Gordon J. Alexander

University of Minnesota - Twin Cities - Carlson School of Management

Alexandre M. Baptista

George Washington University - School of Business

Shu Yan

Oklahoma State University - Stillwater - Department of Finance

Abstract

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

Suggested Citation

Alexander, Gordon J. and Baptista, Alexandre M. and Yan, Shu, 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, Available at SSRN: https://ssrn.com/abstract=1263493

Gordon J. Alexander

University of Minnesota - Twin Cities - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States
612-624-8598 (Phone)
612-624-1335 (Fax)

Alexandre M. Baptista (Contact Author)

George Washington University - School of Business ( email )

School of Business, Funger Hall, Suite 501
2201 G Street, NW
Washington, DC 20052
United States
202-994-3309 (Phone)
202-994-5014 (Fax)

HOME PAGE: http://home.gwu.edu/~alexbapt/

Shu Yan

Oklahoma State University - Stillwater - Department of Finance ( email )

Spears School of Business
Stillwater, OK 74078-4011
United States

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