The Economic Value of Estimated Portfolio Rules Under General Utility Specifications

34 Pages Posted: 19 Jul 2010 Last revised: 7 Dec 2012

See all articles by Bradley S. Paye

Bradley S. Paye

Virginia Polytechnic Institute & State University - Department of Finance, Insurance, and Business Law

Date Written: December 6, 2012

Abstract

This paper addresses the economic value of estimated portfolio rules under general utility. Incorporating estimation risk magnifies errors associated with mean-variance approximations to the economic value of portfolio rules. In fact, for some preference specifications, including CRRA utility, the approximation error can be unboundedly large. The paper proposes two methods designed to curb the effects of estimation risk in a general utility setting. The first involves constraining portfolio weights to reside within the unit simplex. The second involves forming combinations of estimators and characterizes optimal combining weights using standard portfolio formulas. Both approaches dramatically improve portfolio performance in simulation and out-of-sample environments.

Keywords: Combined estimators, Shrinkage, Portfolio choice, Estimation risk

JEL Classification: G1, C13

Suggested Citation

Paye, Bradley S., The Economic Value of Estimated Portfolio Rules Under General Utility Specifications (December 6, 2012). Available at SSRN: https://ssrn.com/abstract=1645419 or http://dx.doi.org/10.2139/ssrn.1645419

Bradley S. Paye (Contact Author)

Virginia Polytechnic Institute & State University - Department of Finance, Insurance, and Business Law ( email )

1016 Pamplin Hall (0221)
Blacksburg, VA 24060-0221
United States

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