Incorporating Economic Objectives into Bayesian Priors: Portfolio Choice Under Parameter Uncertainty

45 Pages Posted: 5 Mar 2007 Last revised: 15 Nov 2013

See all articles by Jun Tu

Jun Tu

Singapore Management University - Lee Kong Chian School of Business

Guofu Zhou

Washington University in St. Louis - John M. Olin Business School; China Academy of Financial Research (CAFR)

Date Written: March 1, 2008

Abstract

Economic objectives are often ignored when estimating parameters, though the loss of doing so can be substantial. This paper proposes a way to allow Bayesian priors to reflect the objectives. Using monthly returns of the Fama-French 25 size and book-to-market portfolios and their three factors from January 1965 to December 2004, we find that investment performance under the objective-based priors can be significantly different from that under alternative priors, with differences in terms of annual certainty-equivalent returns greater than 10% in many cases. In terms of out-of-sample performance, the Bayesian rules under the objective-based priors can outperform substantially some of the best rules developed in the classical framework.

Keywords: Portfolio choice, Parameter uncertainty, Bayesian priors

JEL Classification: G11, G12, C11

Suggested Citation

Tu, Jun and Zhou, Guofu, Incorporating Economic Objectives into Bayesian Priors: Portfolio Choice Under Parameter Uncertainty (March 1, 2008). Available at SSRN: https://ssrn.com/abstract=968223 or http://dx.doi.org/10.2139/ssrn.968223

Jun Tu (Contact Author)

Singapore Management University - Lee Kong Chian School of Business ( email )

50 Stamford Road
#04-01
Singapore, 178899
Singapore

Guofu Zhou

Washington University in St. Louis - John M. Olin Business School ( email )

Washington University
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-6384 (Phone)
314-658-6359 (Fax)

HOME PAGE: http://apps.olin.wustl.edu/faculty/zhou/

China Academy of Financial Research (CAFR)

Shanghai Advanced Institute of Finance
Shanghai P.R.China, 200030
China

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