Optimal Portfolio Choice with Unknown Benchmark Efficiency
74 Pages Posted: 23 Feb 2021 Last revised: 23 May 2023
Date Written: May 21, 2023
Abstract
When a benchmark model is inefficient, including test assets in addition to the benchmark portfolios can improve the performance of the optimal portfolio. In reality, the efficiency of a benchmark model relative to the test assets is ex ante unknown; moreover, the optimal portfolio is constructed based on estimated parameters. Therefore, whether and how to include the test assets becomes a critical question faced by real world investors. For such a setting, we propose a combining portfolio strategy, optimally balancing the value of including test assets and the effect of estimation errors.
The proposed combining strategy can work together with some existing estimation risk reduction strategies. In both empirical datasets and simulations, we show that our proposed combining strategy performs well.
Keywords: portfolio choice; model efficiency; estimation risk; optimal combining
JEL Classification: G11, G12, C11
Suggested Citation: Suggested Citation