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

44 Pages Posted: 17 Jul 2017  

Long Zhao

University of Texas at Austin, Red McCombs School of Business, Students

Deepayan Chakrabarti

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

Kumar Muthuraman

University of Texas at Austin - McCombs School of Business

Date Written: March 14, 2017

Abstract

This paper focuses on the problem of poor portfolio performance when a minimum-variance portfolio is constructed using the sample estimates. This issue is well documented in the literature and has remained in the spotlight ever since Markowitz (1952). Estimation errors are mostly blamed for this problem. However, we argue that even small unbiased estimation errors can lead to significantly bad performance because the optimization step amplifies errors, that too 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 and handle them differently and appropriately. By using a single parameter held constant over all datasets and time periods, our method achieves excellent performance in both simulation and empirical data. Finally, we show how to use information from the sample mean to construct mean-variance portfolios, which we demonstrate 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 (March 14, 2017). Available at SSRN: https://ssrn.com/abstract=2999407

Long Zhao

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

Austin, TX
United States

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 - McCombs School of Business ( email )

Austin, TX 78712
United States

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