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How much should portfolios shrink?

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  • Chulwoo Han

Abstract

This paper develops a portfolio model that penalizes the deviation from a reference portfolio. The proposed model renders a robust portfolio that performs superior under parameter uncertainty. Penalizing the deviation also improves the performance of existing shrinkage portfolio models that are suboptimal due to model parameter uncertainty. The equal‐weight portfolio turns out to be a better reference portfolio than the currently holding portfolio even in the presence of transaction costs. A data‐driven method for determining the degree of penalization is offered. Comprehensive simulation and empirical studies suggest that the proposed model significantly outperforms various existing models.

Suggested Citation

  • Chulwoo Han, 2020. "How much should portfolios shrink?," Financial Management, Financial Management Association International, vol. 49(3), pages 707-740, September.
    • Handle: RePEc:bla:finmgt:v:49:y:2020:i:3:p:707-740
    DOI: 10.1111/fima.12282
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    References listed on IDEAS

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    Cited by:

    1. De Nard, Gianluca & Zhao, Zhao, 2023. "Using, taming or avoiding the factor zoo? A double-shrinkage estimator for covariance matrices," Journal of Empirical Finance, Elsevier, vol. 72(C), pages 23-35.

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