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A new method for better portfolio investment: A case of the Korean stock market

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  • Eom, Cheoljun
  • Park, Jong Won

Abstract

In this study, a method is devised to estimate a correlation matrix capable of constructing a well-diversified portfolio by the Markowitz mean-variance (MV) optimization function (MVOF), after which evidence is presented to empirically prove that the proposed method effectively reduces the sensitivity of portfolio output caused by the error of input variables, such as the mean and standard deviation of stocks in a portfolio. The proposed method removes the property of a market factor included in the sample correlation matrix through random matrix theory. The results demonstrate the comparative advantage of the proposed method in effectively reducing the sensitivity on both the estimation error and the prediction error from the mean and standard deviation. In particular, this comparative advantage is dependent on the striking reduction of portfolio risk gained by constructing the well-diversified portfolio. The proposed method also achieves high investment performance in the risk-return domain, and is particularly stronger in the unstable situation of either a market crash or a higher-risk portfolio. Consequently, this study offers new insight into how to enhance the practical applicability of the MVOF by controlling the property of the market factor in the sample correlation matrix.

Suggested Citation

  • Eom, Cheoljun & Park, Jong Won, 2018. "A new method for better portfolio investment: A case of the Korean stock market," Pacific-Basin Finance Journal, Elsevier, vol. 49(C), pages 213-231.
    • Handle: RePEc:eee:pacfin:v:49:y:2018:i:c:p:213-231
    DOI: 10.1016/j.pacfin.2018.05.002
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    Cited by:

    1. Dai, Yun-Shi & Huynh, Ngoc Quang Anh & Zheng, Qing-Huan & Zhou, Wei-Xing, 2022. "Correlation structure analysis of the global agricultural futures market," Research in International Business and Finance, Elsevier, vol. 61(C).
    2. Eom, Cheoljun & Park, Jong Won, 2021. "Investor attention, firm-specific characteristic, and momentum: A case of the Korean stock market," Research in International Business and Finance, Elsevier, vol. 57(C).
    3. Eom, Cheoljun & Kaizoji, Taisei & Livan, Giacomo & Scalas, Enrico, 2021. "Limitations of portfolio diversification through fat tails of the return Distributions: Some empirical evidence," The North American Journal of Economics and Finance, Elsevier, vol. 56(C).

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    More about this item

    Keywords

    Mean-variance portfolio optimization; Correlation matrix; Random matrix theory; Non-market correlation matrix; Sensitivity test; Simulation experiment;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • C10 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - General

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