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Mean-variance optimization using forward-looking return estimates

Author

Listed:
  • Patrick Bielstein

    (Technical University of Munich)

  • Matthias X. Hanauer

    (Technical University of Munich)

Abstract

Despite its theoretical appeal, Markowitz mean-variance portfolio optimization is plagued by practical issues. It is especially difficult to obtain reliable estimates of a stock’s expected return. Recent research has therefore focused on minimum volatility portfolio optimization, which implicitly assumes that expected returns for all assets are equal. We argue that investors are better off using the implied cost of capital based on analysts’ earnings forecasts as a forward-looking return estimate. Correcting for predictable analyst forecast errors, we demonstrate that mean-variance optimized portfolios based on these estimates outperform on both an absolute and a risk-adjusted basis the minimum volatility portfolio as well as naive benchmarks, such as the value-weighted and equally-weighted market portfolio. The results continue to hold when extending the sample to international markets, using different methods for estimating the forward-looking return, including transaction costs, and using different optimization constraints.

Suggested Citation

  • Patrick Bielstein & Matthias X. Hanauer, 2019. "Mean-variance optimization using forward-looking return estimates," Review of Quantitative Finance and Accounting, Springer, vol. 52(3), pages 815-840, April.
    • Handle: RePEc:kap:rqfnac:v:52:y:2019:i:3:d:10.1007_s11156-018-0727-4
    DOI: 10.1007/s11156-018-0727-4
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    Cited by:

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    2. Vitor Azevedo & Patrick Bielstein & Manuel Gerhart, 2021. "Earnings forecasts: the case for combining analysts’ estimates with a cross-sectional model," Review of Quantitative Finance and Accounting, Springer, vol. 56(2), pages 545-579, February.
    3. Hendriock, Mario, 2020. "Implied cost of capital and mutual fund performance," CFR Working Papers 20-11, University of Cologne, Centre for Financial Research (CFR).

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    More about this item

    Keywords

    Portfolio optimization; Expected returns; Implied cost of capital; Momentum; Maximum sharpe ratio;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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