Parameter uncertainty in portfolio selection: Shrinking the inverse covariance matrix

Apostolos Kourtis, George Dotsis and Raphael Markellos

Journal of Banking & Finance, 2012, vol. 36, issue 9, 2522-2531

Abstract: The estimation of the inverse covariance matrix plays a crucial role in optimal portfolio choice. We propose a new estimation framework that focuses on enhancing portfolio performance. The framework applies the statistical methodology of shrinkage directly to the inverse covariance matrix using two non-parametric methods. The first minimises the out-of-sample portfolio variance while the second aims to increase out-of-sample risk-adjusted returns. We apply the resulting estimators to compute the minimum variance portfolio weights and obtain a set of new portfolio strategies. These strategies have an intuitive form which allows us to extend our framework to account for short-sale constraints, transaction costs and singular covariance matrices. A comparative empirical analysis against several strategies from the literature shows that the new strategies often offer higher risk-adjusted returns and lower levels of risk.

Keywords: Portfolio optimisation; Inverse covariance matrix; Estimation risk; Shrinkage (search for similar items in EconPapers)
JEL-codes: C13 C51 C61 G11 (search for similar items in EconPapers)
Date: 2012
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (39)

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0378426612001331
Full text for ScienceDirect subscribers only

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:eee:jbfina:v:36:y:2012:i:9:p:2522-2531

DOI: 10.1016/j.jbankfin.2012.05.005

Access Statistics for this article

Journal of Banking & Finance is currently edited by Ike Mathur

More articles in Journal of Banking & Finance from Elsevier
Bibliographic data for series maintained by Catherine Liu ().