Optimal portfolio allocation with uncertain covariance matrix

Maxime Markov and Vladimir Markov

Papers from arXiv.org

Abstract: In this paper, we explore the portfolio allocation problem involving an uncertain covariance matrix. We calculate the expected value of the Constant Absolute Risk Aversion (CARA) utility function, marginalized over a distribution of covariance matrices. We show that marginalization introduces a logarithmic dependence on risk, as opposed to the linear dependence assumed in the mean-variance approach. Additionally, it leads to a decrease in the allocation level for higher uncertainties. Our proposed method extends the mean-variance approach by considering the uncertainty associated with future covariance matrices and expected returns, which is important for practical applications.

Date: 2023-11
New Economics Papers: this item is included in nep-rmg and nep-upt
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Persistent link: https://EconPapers.repec.org/RePEc:arx:papers:2311.07478

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