Estimation risk modeling in optimal portfolio selection: an empirical study from emerging markets.

Abstract

The optimal portfolios seem not being as efficient as intended. Especially during financial crisis period optimal portfolio is not an optimal investment as it does not yield maximum return given a specific level of risk, vice and versa. One possible explanation for an unimpressive performance of the seemingly efficient portfolio is incorrectness in parameter estimates called “estimation risk in parameter estimates”. Five different estimating strategies are employed to explore ex post portfolio performance when estimation risk is incorporated. Among the five alternative strategies, shrinkage estimators incorporating the single index model outperforms other traditional portfolio selection strategies. Allowing for asset mispricing and applying Bayesian shrinkage adjusted factor to each asset’s alpha, a single factor namely excess market return is adequate in alleviating estimation uncertainty.