Improved Estimates of Correlation Coefficients and Their Impact on Optimum Portfolios

16 Pages Posted: 19 May 2006

See all articles by Edwin J. Elton

Edwin J. Elton

New York University (NYU) - Department of Finance

Martin J. Gruber

New York University (NYU) - Department of Finance

Jonathan F. Spitzer

University of Virginia - Darden School of Business

Abstract

To implement mean variance analysis one needs a technique for forecasting correlation coefficients. In this article we investigate the ability of several techniques to forecast correlation coefficients between securities. We find that separately forecasting the average level of pairwise correlations and individual pairwise differences from the average improves forecasting accuracy. Furthermore, forming homogenous groups of firms on the basis of industry membership or firm attributes (e.g. size) improves forecast accuracy. Accuracy is evaluated in two ways: First, in terms of the error in estimating future correlation coefficients. Second, in the characteristics of portfolios formed on the basis of each forecasting technique. The ranking of forecasting techniques is robust across both methods of evaluation and the better techniques outperform prior suggestions in the literature of financial economics.

Suggested Citation

Elton, Edwin J. and Gruber, Martin J. and Spitzer, Jonathan F., Improved Estimates of Correlation Coefficients and Their Impact on Optimum Portfolios. European Financial Management, Vol. 12, No. 3, pp. 303-318, June 2006. Available at SSRN: https://ssrn.com/abstract=903197 or http://dx.doi.org/10.1111/j.1354-7798.2006.00322.x

Edwin J. Elton (Contact Author)

New York University (NYU) - Department of Finance ( email )

44 West 4th Street
Ste 9-190
New York, NY 10012-1126
United States
212-998-0361 (Phone)
212-995-4233 (Fax)

Martin J. Gruber

New York University (NYU) - Department of Finance ( email )

44 West 4th Street
Ste 9-190
New York, NY 10012-1126
United States
212-998-0333 (Phone)
212-995-4233 (Fax)

Jonathan F. Spitzer

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
4349822681 (Phone)
4342434351 (Fax)

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