Incorporating Estimation Risk in Portfolio Choice

CentER Working Paper No. 65

35 Pages Posted: 28 Dec 2000

See all articles by Jenke ter Horst

Jenke ter Horst

TIAS School for Business and Society

Frans de Roon

Tilburg University - Department of Finance

Bas J. M. Werker

Tilburg University - Center for Economic Research (CentER)

Date Written: February 2002

Abstract

We propose a new adjustment in mean-variance portfolio weights to incorporate uncertainty caused by the fact that, in general, we have to use estimated expected returns when determining optimal portfolios. The adjustment amounts to using a higher pseudo risk-aversion rather than the actual risk-aversion and has a straightforward interpretation. The difference between the actual and the pseudo risk-aversion depends on the sample size, the number of assets in the portfolio, and the curvature of the mean-variance frontier. We show how short sales constraints and time-varying expected returns are incorporated in our framework. Applying the adjustment to international portfolios, we show that the adjustments are nontrivial for G5 country portfolios and that they are even more important when emerging markets are included. The exclusion of short sales is found to have a further important impact on the adjusted portfolio weights. In case expected country returns are time- varying, our adjustment induces a significantly smaller variability in portfolio weights that is commonly found.

Suggested Citation

ter Horst, Jenke R. and de Roon, Frans A. and Werker, Bas J.M., Incorporating Estimation Risk in Portfolio Choice (February 2002). CentER Working Paper No. 65. Available at SSRN: https://ssrn.com/abstract=244695 or http://dx.doi.org/10.2139/ssrn.244695

Jenke R. Ter Horst (Contact Author)

TIAS School for Business and Society ( email )

Warandelaan 2
TIAS Building
Tilburg, Noord Brabant 5037 AB
Netherlands

Frans A. De Roon

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 1 3466 8361/3025 (Phone)
+31 1 3466 2875 (Fax)

Bas J.M. Werker

Tilburg University - Center for Economic Research (CentER) ( email )

Econometrics and Finance Group
5000 LE Tilburg
Netherlands

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