Confidence in prior knowledge: Calibration and impact on portfolio performance

Tobias Wickern

No 7/11, Discussion Papers in Econometrics and Statistics from University of Cologne, Institute of Econometrics and Statistics

Abstract: The specification of prior parameters is a common practical problem when implementing Bayesian approaches to portfolio optimization. The precision parameter of the prior on the expected asset returns reflects the confidence of the investor in the prior knowledge. Within the framework of the normal-inverse-Wishart model, this paper investigates which factors drive this confidence in order to deduce reasonable values of the precision parameter. We recommend that the investor concentrates on the specification of the precision parameter. By contrast, experts should assess the values of the prior location and dispersion parameter. In the second part of the paper, the impact of the investor's confidence on the performance of investment strategies is examined by a simulation study. The study focusses less on detecting superior portfolio strategies, and more on providing a sensitivity analysis for different levels of confidence. In addition, we show how the posterior distribution of the normal-inverse-Wishart model can be used as a starting point of a simulation process.

Keywords: Bayesian portfolio optimization; Conjugate prior; Confidence parameter; Normal-inverse-Wishart model; Tangency portfolio; Markowitz; Sharpe ratio; Sensitivity analysis; Simulation study (search for similar items in EconPapers)
JEL-codes: C11 C15 G11 (search for similar items in EconPapers)
Date: 2011
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
https://www.econstor.eu/bitstream/10419/67612/1/684352133.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:zbw:ucdpse:711

Access Statistics for this paper

More papers in Discussion Papers in Econometrics and Statistics from University of Cologne, Institute of Econometrics and Statistics Contact information at EDIRC.
Bibliographic data for series maintained by ZBW - Leibniz Information Centre for Economics ().