A Stability Approach to Mean-Variance Optimization
Financial Review 50, 3, 301-330.
42 Pages Posted: 18 Jul 2015
Date Written: January 09, 2015
I jointly treat two critical issues in the application of mean-variance portfolios, i.e., estimation risk and portfolio instability. I find that theory-based portfolio strategies known to outperform naive diversification (1/N) in the absence of transaction costs, heavily underperform it under transaction costs. This is because they are highly unstable over time. I propose a generic method to stabilize any given portfolio strategy while maintaining or improving its efficiency. My empirical analysis confirms that the new method leads to stable and efficient portfolios that offer equal or lower turnover than 1/N and larger Sharpe ratio, even under high transaction costs.
Keywords: Portfolio Choice, Stability, Estimation Risk, Transaction Costs
JEL Classification: C13, C51, C61, G11
Suggested Citation: Suggested Citation