Portfolio optimization when expected stock returns are determined by exposure to risk

Details Portfolio optimization when expected stock returns are determined by exposure to risk Portfolio optimization when expected stock returns are determined by exposure to risk

2009-06-12

arxiv.org/abs/0906.2271v1

Bernoulli 2009, Vol. 15, No. 2, 464-474

Mathematics

Statistics Theory

Published in at http://dx.doi.org/10.3150/08-BEJ163 the Bernoulli (http://isi.cbs.nl/bernoulli/) by the International Statisti

Scientific paper

10.3150/08-BEJ163

It is widely recognized that when classical optimal strategies are applied with parameters estimated from data, the resulting portfolio weights are remarkably volatile and unstable over time. The predominant explanation for this is the difficulty of estimating expected returns accurately. In this paper, we modify the $n$ stock Black--Scholes model by introducing a new parametrization of the drift rates. We solve Markowitz' continuous time portfolio problem in this framework. The optimal portfolio weights correspond to keeping $1/n$ of the wealth invested in stocks in each of the $n$ Brownian motions. The strategy is applied out-of-sample to a large data set. The portfolio weights are stable over time and obtain a significantly higher Sharpe ratio than the classical $1/n$ strategy.

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