Portfolio Selection with Parameter and Model Uncertainty: A Multi-Prior Approach

52 Pages Posted: 24 Feb 2005

See all articles by Lorenzo Garlappi

Lorenzo Garlappi

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

Tan Wang

University of British Columbia (UBC) - Division of Finance; China Academy of Financial Research (CAFR)

Raman Uppal

EDHEC Business School; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: April 2004

Abstract

In this paper, we extend the mean-variance portfolio model where expected returns are obtained using maximum likelihood estimation to explicitly account for uncertainty about the estimated expected returns. In contrast to the Bayesian approach to estimation error, where there is only a single prior and the investor is neutral to uncertainty, we allow for multiple priors and aversion to uncertainty. We characterize the set of priors as a confidence interval around the estimated value of expected return and we model aversion to uncertainty via a minimization over the set of priors. The multi-prior model has several attractive features: One, just like the Bayesian model, the multi-prior model is firmly grounded in decision theory; Two, it is flexible enough to allow for uncertainty about expected returns estimated jointly for all assets or different levels of uncertainty about expected returns for different subsets of the assets; Three, we show how in several special cases of the multi-prior model one can obtain closed-form expressions for the optimal portfolio, which can be interpreted as a shrinkage of the mean-variance portfolio towards either the risk-free asset or the minimum variance portfolio. We illustrate how to implement the multi-prior model using both international and domestic data. Our analysis suggests that allowing for parameter uncertainty reduces the fluctuation of portfolio weights over time and, for the data set considered, improves the out-of sample performance.

Keywords: Portfolio choice, asset allocation, estimation

JEL Classification: G11, D81

Suggested Citation

Garlappi, Lorenzo and Wang, Tan and Uppal, Raman, Portfolio Selection with Parameter and Model Uncertainty: A Multi-Prior Approach (April 2004). EFA 2005 Moscow Meetings Paper; Sauder School of Business Working Paper. Available at SSRN: https://ssrn.com/abstract=671981 or http://dx.doi.org/10.2139/ssrn.671981

Lorenzo Garlappi

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

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada

Tan Wang

University of British Columbia (UBC) - Division of Finance ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada
604-822-9414 (Phone)
604-822-8521 (Fax)

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

Raman Uppal (Contact Author)

EDHEC Business School ( email )

58 rue du Port
Lille, 59046
France

Centre for Economic Policy Research (CEPR)

90-98 Goswell Road
London, EC1V 7RR
United Kingdom

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