Cross-Validation Based Covariance Shrinkage in Portfolio Selection

quantf research Working Paper Series: WP03/2014

33 Pages Posted: 2 Jun 2014

See all articles by Fotis Papailias

Fotis Papailias

Quantf Research; University of London, King's College London, Department of Management

George Kapetanios

King's College, London

Date Written: June 1, 2014

Abstract

In this paper we investigate the applied performance of covariance shrinkage in the portfolio optimisation problem. We suggest that the optimal shrinkage coefficient should be obtained from a numerical optimisation of a function with financial interpretation. Such a function could be the minimisation of the standard deviation of the portfolio returns or the maximisation of the Sharpe Ratio of the portfolio. Empirical evidence indicates that this methodology results in portfolios with better risk/return characteristics.

Keywords: Covariance Matrix, Shrinkage Methods, Portfolio Optimisation

Suggested Citation

Papailias, Fotis and Kapetanios, George, Cross-Validation Based Covariance Shrinkage in Portfolio Selection (June 1, 2014). quantf research Working Paper Series: WP03/2014, Available at SSRN: https://ssrn.com/abstract=2444389 or http://dx.doi.org/10.2139/ssrn.2444389

Fotis Papailias (Contact Author)

Quantf Research ( email )

London
United Kingdom

HOME PAGE: http://www.quantf.com

University of London, King's College London, Department of Management ( email )

150 Stamford Street
London, SE1 9NN
United Kingdom

George Kapetanios

King's College, London ( email )

30 Aldwych
London, WC2B 4BG
United Kingdom
+44 20 78484951 (Phone)

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