Portfolio Optimization: The Case for Rank and Sign in Expected Returns

43 Pages Posted: 1 Aug 2023 Last revised: 6 Feb 2024

See all articles by Anthony Sanford

Anthony Sanford

HEC Montreal - Department of Finance

Date Written: July 29, 2023

Abstract

The portfolio theory literature has long strived for perfection when it comes to estimating expected returns. In this paper we develop a theoretical framework which shows that perfect (known) expected returns may not be necessary for (optimal) portfolio optimizations. Using simulated data, we show that results from a portfolio constructed using perfect expected returns do not outperform those whose results are "shocked." Our findings suggest that optimizations using correctly ranked expected returns outperform portfolios whose expected returns are known. We confirm these results empirically using option-recovered expected idiosyncratic returns which outperform other benchmark portfolio optimization models.

Keywords: Portfolio theory, expected returns, mean-variance, ranking, recovery theorem

JEL Classification: G12, G13, G14, G17

Suggested Citation

Sanford, Anthony, Portfolio Optimization: The Case for Rank and Sign in Expected Returns (July 29, 2023). Available at SSRN: https://ssrn.com/abstract=4525782 or http://dx.doi.org/10.2139/ssrn.4525782

Anthony Sanford (Contact Author)

HEC Montreal - Department of Finance ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7
Canada

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