Forecast Risk Bias in Optimized Portfolios, October 2009

12 Pages Posted: 21 Nov 2009

Date Written: October 16, 2009

Abstract

When there is noise in a covariance matrix, portfolio optimization tends to produce portfolios for which the risk forecasts are underestimates of the true risk. In this paper, we take a closer look at the connection between estimation error and the underestimation of the risk of optimized portfolios. We pay special attention to the case in which returns have a known factor structure. There, the bias in optimization can be reduced dramatically by using a covariance matrix based on a factor model, rather than one computed from historical asset covariances. Moreover, our analysis reveals that for many active portfolios, the bias in factor-model forecasts is less than previously thought. Lastly, we discuss the role of constraints in mitigating risk forecasting bias.

Keywords: forecast risk bias optimized portfolios covariance matrix underestimates true risk factor structure returns

Suggested Citation

Bender, Jennifer and Lee, Jyh-Huei and Stefek, Dan and Yao, Jian (Jay), Forecast Risk Bias in Optimized Portfolios, October 2009 (October 16, 2009). MSCI Barra Research Paper No. 2009-36, Available at SSRN: https://ssrn.com/abstract=1509628 or http://dx.doi.org/10.2139/ssrn.1509628

Jennifer Bender (Contact Author)

State Street Global Advisors ( email )

1 Lincoln Street
28th Floor
Boston, MA 02111
United States

Jyh-Huei Lee

MSCI Inc. ( email )

88 Pine Street
2nd Floor
New York, NY 10005
United States

Dan Stefek

MSCI Inc. ( email )

88 Pine Street
2nd Floor
New York, NY 10005
United States

Jian (Jay) Yao

MSCI Inc. ( email )

88 Pine Street
2nd Floor
New York, NY 10005
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
284
Abstract Views
1,403
Rank
211,021
PlumX Metrics