Bernoulli

Portfolio optimization when expected stock returns are determined by exposure to risk

Carl Lindberg

Full-text: Open access

Abstract

It is widely recognized that when classical optimal strategies are applied with parameters estimated from data, the resulting portfolio weights are remarkably volatile and unstable over time. The predominant explanation for this is the difficulty of estimating expected returns accurately. In this paper, we modify the n stock Black–Scholes model by introducing a new parametrization of the drift rates. We solve Markowitz’ continuous time portfolio problem in this framework. The optimal portfolio weights correspond to keeping 1/n of the wealth invested in stocks in each of the n Brownian motions. The strategy is applied out-of-sample to a large data set. The portfolio weights are stable over time and obtain a significantly higher Sharpe ratio than the classical 1/n strategy.

Article information

Source
Bernoulli Volume 15, Number 2 (2009), 464-474.

Dates
First available: 4 May 2009

Permanent link to this document
http://projecteuclid.org/euclid.bj/1241444898

Digital Object Identifier
doi:10.3150/08-BEJ163

Mathematical Reviews number (MathSciNet)
MR2543870

Zentralblatt MATH identifier
1200.91284

Citation

Lindberg, Carl. Portfolio optimization when expected stock returns are determined by exposure to risk. Bernoulli 15 (2009), no. 2, 464--474. doi:10.3150/08-BEJ163. http://projecteuclid.org/euclid.bj/1241444898.


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