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

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  • Carl Lindberg

Abstract

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.

Suggested Citation

  • Carl Lindberg, 2009. "Portfolio optimization when expected stock returns are determined by exposure to risk," Papers 0906.2271, arXiv.org.
  • Handle: RePEc:arx:papers:0906.2271
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    Cited by:

    1. Ankit Dangi, 2013. "Financial Portfolio Optimization: Computationally guided agents to investigate, analyse and invest!?," Papers 1301.4194, arXiv.org.
    2. Pushpa Narayan Rathie & Luan Carlos de Sena Monteiro Ozelim & Bernardo Borba de Andrade, 2021. "Portfolio Management of Copula-Dependent Assets Based on P ( Y < X ) Reliability Models: Revisiting Frank Copula and Dagum Distributions," Stats, MDPI, vol. 4(4), pages 1-24, December.
    3. repec:dau:papers:123456789/4688 is not listed on IDEAS
    4. Carl Lindberg, 2013. "Investing equally in risk," Decisions in Economics and Finance, Springer;Associazione per la Matematica, vol. 36(1), pages 39-46, May.
    5. B. Vasilyev, 2015. "Using Intrinsic Time In Portfolio Optimization," Review of Business and Economics Studies // Review of Business and Economics Studies, Финансовый Университет // Financial University, vol. 3(2), pages 7-14.
    6. Roberto Savona & Cesare Orsini, 2019. "Taking the right course navigating the ERC universe," Journal of Asset Management, Palgrave Macmillan, vol. 20(3), pages 157-174, May.
    7. Özge Alp & Ralf Korn, 2011. "Continuous-time mean-variance portfolio optimization in a jump-diffusion market," Decisions in Economics and Finance, Springer;Associazione per la Matematica, vol. 34(1), pages 21-40, May.
    8. Thorsten Poddig & Albina Unger, 2012. "On the robustness of risk-based asset allocations," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 26(3), pages 369-401, September.

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