Estimation error in mean returns and the mean-variance efficient frontier
Yusif Simaan and
International Review of Economics & Finance, 2018, vol. 56, issue C, 109-124
In this paper, we build estimation error in mean returns into the mean-variance (MV) portfolio theory under the assumption that returns on individual assets follow a joint normal distribution. We derive the conditional sampling distribution of the MV portfolio along with its mean and risk return when the sample covariance matrix is equal to the population covariance matrix. We use the mean squared error (MSE) to characterize the effects of estimation error in mean returns on the joint sampling distributions and examine how such error affects the risk-return tradeoff of the MV portfolios. We show that the negative effects of error in mean returns on the joint sampling distributions increase with the decision maker's risk tolerance and the number of assets in a portfolio, but decrease with the sample size.
Keywords: Portfolio theory; Investment; Estimation error; Multivariate analysis (search for similar items in EconPapers)
JEL-codes: C13 C44 C46 G11 (search for similar items in EconPapers)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:reveco:v:56:y:2018:i:c:p:109-124
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