Journal of Finance and Economics

Journal of Finance and Economics

ISSN: 2291-4951 (Print)    ISSN: 2291-496X (Online)

Volume 2 (2014), No. 2, Pages 54-76

DOI: 10.12735/jfe.v2i2p54

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Portfolio Optimization via Generalized Multivariate Shrinkage

Xiaochun Liu1 

1Department of Economics, Emory University, Atlanta, USA

URL: https://doi.org/10.12735/jfe.v2i2p54Citation: 1 (Details)

To Cite this Article     Article Views: 835     Downloads: 467  Since January, 2015

Abstract

The shrinkage method of Ledoit and Wolf (2003; 2004a; 2004b) has shown certain success in estimating a well-conditioned covariance matrix for high dimensional portfolios. This paper generalizes the shrinkage method of Ledoit and Wolf to a multivariate shrinkage setting, by which the well-conditioned covariance matrix is estimated using the weighted averaging of multiple priors, instead of single ones. In fact, it can be argued that the generalized multivariate shrinkage approach reduces estimation errors and uncertainty when projecting the true covariance matrix onto the line, spanned by priors joining to the sample covariance matrix. Hence, the generalized multivariate shrinkage is less subjected to sampling variation. Empirically, I use the U.S. firms to form portfolios for out-of-sample forecast. Using Ledoit and Wolf's approach as benchmark, out-of-sample portfolios constructed from the proposed method gain significant variance reductions and sizable improvement of information ratios.

JEL Classifications: G11, G12

Keywords: generalized multivariate shrinkage, portfolio selection, covariance estimation, shrinkage intensity, multiple priors

To Cite this Article: Liu, X. (2014). Portfolio optimization via generalized multivariate shrinkage. Journal of Finance and Economics, 2(2), 54-76. https://doi.org/10.12735/jfe.v2i2p54

Copyright © Xiaochun Liu

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This article is published under license to Science and Education Centre of North America. This is an Open Access article distributed under the terms of the Creative Commons Attribution 4.0 International License.

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Portfolio Optimization via Generalized Multivariate Shrinkage
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