Covariance Misspecification in Asset Allocation

Posted: 8 Aug 2006

See all articles by Steven P. Peterson

Steven P. Peterson

Virginia Commonwealth University - School of Business - Department of Economics

John T. Grier

Government of the Commonwealth of Virginia

Abstract

Series of returns to broad asset classes often possess histories of unequal length and have been subject to smoothing. Estimates of covariances are generally based on the common, although shorter, series length, and covariances for smoothed series are necessarily biased downward. These characteristics pose serious problems that can generate suboptimal and misleading allocations among asset classes. The article discusses elements of the underlying theory in proposing an informationally efficient covariance estimator. The estimator is then compared with conventional covariance estimates in an empirical application. Covariance estimates are found to be sensitive to both truncated estimates involving shorter series and the effects of smoothing.

Keywords: Portfolio Management, Asset Allocation; Alternative Investments, Other; Risk Measurement and Management, Advanced Risk Tools

Suggested Citation

Peterson, Steven P. and Grier, John T., Covariance Misspecification in Asset Allocation. Financial Analysts Journal, Vol. 62, No. 4, pp. 76-85, July/August 2006, Available at SSRN: https://ssrn.com/abstract=922307

Steven P. Peterson (Contact Author)

Virginia Commonwealth University - School of Business - Department of Economics ( email )

Box 844000
Richmond, VA 23284-4000
United States

John T. Grier

Government of the Commonwealth of Virginia ( email )

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