Specification Error, Estimation Risk, and Conditional Portfolio Rules

26 Pages Posted: 3 Jun 2017

See all articles by Murray Carlson

Murray Carlson

University of British Columbia (UBC) - Sauder School of Business

David A. Chapman

McIntire School, University of Virginia

Ron Kaniel

University of Rochester - Simon Business School; CEPR

Hong Yan

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)

Date Written: June 2017

Abstract

In characterizing the data‐generating process for excess returns, an investor faces both parameter uncertainty (or “estimation risk”) and specification error. We examine the trade‐off between these two effects, in the context of an optimal consumption/portfolio decision problem, by considering a minimal extension of the standard assumption of a linear vector autoregression for excess returns. The key additional assumption in our data‐generating process is a positive linear relationship between market volatility and lagged market dividend yields. This simple specification is consistent with a long sample of U.S. data. We show that volatility adjusted rules are substantially less sensitive to variation in dividend yields, and volatility‐related specification error is economically significant – even when the decisions are based on sample estimates from data sets of a realistic size.

Suggested Citation

Carlson, Murray D. and Chapman, David A. and Kaniel, Ron and Yan, Hong, Specification Error, Estimation Risk, and Conditional Portfolio Rules (June 2017). International Review of Finance, Vol. 17, Issue 2, pp. 263-288, 2017. Available at SSRN: https://ssrn.com/abstract=2979689 or http://dx.doi.org/10.1111/irfi.12110

Murray D. Carlson (Contact Author)

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada
604-822-8358 (Phone)

David A. Chapman

McIntire School, University of Virginia ( email )

P.O. Box 400173
Charlottesville, VA 22904-4173
United States

HOME PAGE: http://https://sites.google.com/site/davidchapmanswebsite/

Ron Kaniel

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

HOME PAGE: http://rkaniel.simon.rochester.edu

CEPR ( email )

London
United Kingdom

Hong Yan

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

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