Selecting an Asset Allocation in the Presence of Sampling Error
Macquarie Applied Finance Centre Research Paper
55 Pages Posted: 20 May 2005 Last revised: 7 Jan 2008
Date Written: May 2, 2005
Investors choose asset allocations to best meet their needs. Expected utility is one basis for that choice. Investors may also consider Sharpe ratios, Sortino ratios and other measures in making their choices. Expected utility and other measures are functions of moments of the return process - moments which are estimated with error. This error materially impacts the estimate of the function values so that often we cannot distinguish between different asset allocations, let alone decide which allocation is superior. As a result, investment advisers may struggle to demonstrate that their recommended allocation is superior to another, such as a market-weighted allocation.
Keywords: expected utility, sortino ratio, skewness, kurtosis, estimation error, GMM, asset allocation, portfolio choice
JEL Classification: C1, G1
Suggested Citation: Suggested Citation