Portfolio Construction by Mitigating Error Amplification: The Bounded-Noise Portfolio

35 Pages Posted: 17 Jul 2017 Last revised: 23 Oct 2018

See all articles by Long Zhao

Long Zhao

NUS Business School

Deepayan Chakrabarti

University of Texas at Austin - Department of Information, Risk and Operations Management

Kumar Muthuraman

University of Texas at Austin - Red McCombs School of Business

Date Written: September 7, 2018

Abstract

We address the problem of poor portfolio performance when a minimum-variance portfolio is constructed using the sample estimates. Estimation errors are mostly blamed for the poor portfolio performance. However, we argue that even small unbiased estimation errors can lead to significantly bad performance because the optimization step amplifies errors, in a non-symmetric way. Instead of trying to independently improve the estimation step or fix the optimization step for robustness, we disentangle the well-estimated aspects from the poorly-estimated aspects of the covariance matrix. By using a single parameter held constant over all datasets and time periods, our method achieves excellent performance both empirically and in the simulation. We also show how to use information from the sample mean to construct mean-variance portfolios that have higher out-of-sample Sharpe ratios.

Keywords: portfolio choice, estimation error

JEL Classification: G11

Suggested Citation

Zhao, Long and Chakrabarti, Deepayan and Muthuraman, Kumar, Portfolio Construction by Mitigating Error Amplification: The Bounded-Noise Portfolio (September 7, 2018). Available at SSRN: https://ssrn.com/abstract=2999407 or http://dx.doi.org/10.2139/ssrn.2999407

Long Zhao

NUS Business School ( email )

15 Kent Ridge Dr
Singapore, Singapore 119245
Singapore

Deepayan Chakrabarti

University of Texas at Austin - Department of Information, Risk and Operations Management ( email )

CBA 5.202
Austin, TX 78712
United States

HOME PAGE: http://https://faculty.mccombs.utexas.edu/deepayan.chakrabarti/

Kumar Muthuraman (Contact Author)

University of Texas at Austin - Red McCombs School of Business ( email )

Austin, TX 78712
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
284
Abstract Views
1,276
rank
128,011
PlumX Metrics