Optimal Shrinkage-Based Portfolio Selection in High Dimensions

Taras Bodnar, Yarema Okhrin and Nestor Parolya

Journal of Business & Economic Statistics, 2022, vol. 41, issue 1, 140-156

Abstract: In this article, we estimate the mean-variance portfolio in the high-dimensional case using the recent results from the theory of random matrices. We construct a linear shrinkage estimator which is distribution-free and is optimal in the sense of maximizing with probability 1 the asymptotic out-of-sample expected utility, that is, mean-variance objective function for different values of risk aversion coefficient which in particular leads to the maximization of the out-of-sample expected utility and to the minimization of the out-of-sample variance. One of the main features of our estimator is the inclusion of the estimation risk related to the sample mean vector into the high-dimensional portfolio optimization. The asymptotic properties of the new estimator are investigated when the number of assets p and the sample size n tend simultaneously to infinity such that p/n→c∈(0,+∞). The results are obtained under weak assumptions imposed on the distribution of the asset returns, namely the existence of the 4+ε moments is only required. Thereafter we perform numerical and empirical studies where the small- and large-sample behavior of the derived estimator is investigated. The suggested estimator shows significant improvements over the existent approaches including the nonlinear shrinkage estimator and the three-fund portfolio rule, especially when the portfolio dimension is larger than the sample size. Moreover, it is robust to deviations from normality.

Date: 2022
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Citations: View citations in EconPapers (7)

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Working Paper: Optimal shrinkage-based portfolio selection in high dimensions (2021)
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DOI: 10.1080/07350015.2021.2004897

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