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Honey, I shrunk the sample covariance matrix

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  • Olivier Ledoit
  • Michael Wolf

Abstract

The central message of this paper is that nobody should be using the sample covariance matrix for the purpose of portfolio optimization. It contains estimation error of the kind most likely to perturb a mean-variance optimizer. In its place, we suggest using the matrix obtained from the sample covariance matrix through a transformation called shrinkage. This tends to pull the most extreme coefficients towards more central values, thereby systematically reducing estimation error where it matters most. Statistically, the challenge is to know the optimal shrinkage intensity, and we give the formula for that. Without changing any other step in the portfolio optimization process, we show on actual stock market data that shrinkage reduces tracking error relative to a benchmark index, and substantially increases the realized information ratio of the active portfolio manager.

Suggested Citation

  • Olivier Ledoit & Michael Wolf, 2003. "Honey, I shrunk the sample covariance matrix," Economics Working Papers 691, Department of Economics and Business, Universitat Pompeu Fabra.
    • Handle: RePEc:upf:upfgen:691
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    References listed on IDEAS

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    1. Ledoit, Olivier & Wolf, Michael, 2004. "A well-conditioned estimator for large-dimensional covariance matrices," Journal of Multivariate Analysis, Elsevier, vol. 88(2), pages 365-411, February.
    2. Connor, Gregory & Korajczyk, Robert A, 1993. "A Test for the Number of Factors in an Approximate Factor Model," Journal of Finance, American Finance Association, vol. 48(4), pages 1263-1291, September.
    3. Ravi Jagannathan & Tongshu Ma, 2003. "Risk Reduction in Large Portfolios: Why Imposing the Wrong Constraints Helps," Journal of Finance, American Finance Association, vol. 58(4), pages 1651-1683, August.
    4. Ledoit, Olivier & Wolf, Michael, 2003. "Improved estimation of the covariance matrix of stock returns with an application to portfolio selection," Journal of Empirical Finance, Elsevier, vol. 10(5), pages 603-621, December.
    5. Jorion, Philippe, 1986. "Bayes-Stein Estimation for Portfolio Analysis," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 21(3), pages 279-292, September.
    6. repec:bla:jfinan:v:58:y:2003:i:4:p:1651-1684 is not listed on IDEAS
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    Citations

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    Cited by:

    1. Caicedo-Llano, Juliana & Dionysopoulos, Thomas, 2008. "Market integration: A risk-budgeting guide for pure alpha investors," Journal of Multinational Financial Management, Elsevier, vol. 18(4), pages 313-327, October.
    2. Daniel Espinoza & Eduardo Moreno, 2014. "A primal-dual aggregation algorithm for minimizing conditional value-at-risk in linear programs," Computational Optimization and Applications, Springer, vol. 59(3), pages 617-638, December.
    3. Loriana Pelizzon & Massimiliano Caporin, 2012. "Market volatility, optimal portfolios and naive asset allocations," Working Papers 2012_08, Department of Economics, University of Venice "Ca' Foscari".
    4. Gopal K. Basak & Ravi Jagannathan & Tongshu Ma, 2004. "A Jackknife Estimator for Tracking Error Variance of Optimal Portfolios Constructed Using Estimated Inputs1," NBER Working Papers 10447, National Bureau of Economic Research, Inc.
    5. Bessler, Wolfgang & Leonhardt, Alexander & Wolff, Dominik, 2016. "Analyzing hedging strategies for fixed income portfolios: A Bayesian approach for model selection," International Review of Financial Analysis, Elsevier, vol. 46(C), pages 239-256.
    6. Guidolin, Massimo & Wang, Kai, 2023. "The empirical performance of option implied volatility surface-driven optimal portfolios," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 618(C).
    7. Michael W. Brandt & Pedro Santa-Clara & Rossen Valkanov, 2009. "Parametric Portfolio Policies: Exploiting Characteristics in the Cross-Section of Equity Returns," The Review of Financial Studies, Society for Financial Studies, vol. 22(9), pages 3411-3447, September.
    8. Michael Wolf, 2006. "Resampling vs. Shrinkage for Benchmarked Managers," IEW - Working Papers 263, Institute for Empirical Research in Economics - University of Zurich.
    9. Perreault, Samuel & Duchesne, Thierry & Nešlehová, Johanna G., 2019. "Detection of block-exchangeable structure in large-scale correlation matrices," Journal of Multivariate Analysis, Elsevier, vol. 169(C), pages 400-422.
    10. Popovic, Gordana C. & Hui, Francis K.C. & Warton, David I., 2018. "A general algorithm for covariance modeling of discrete data," Journal of Multivariate Analysis, Elsevier, vol. 165(C), pages 86-100.
    11. Paolo Andreini & Donato Ceci, 2019. "A Horse Race in High Dimensional Space," CEIS Research Paper 452, Tor Vergata University, CEIS, revised 14 Feb 2019.
    12. Yuanrong Wang & Tomaso Aste, 2021. "Dynamic Portfolio Optimization with Inverse Covariance Clustering," Papers 2112.15499, arXiv.org, revised Jan 2022.
    13. Rubio-García, Álvaro & Fernández-Lorenzo, Samuel & García-Ripoll, Juan José & Porras, Diego, 2024. "Accurate solution of the Index Tracking problem with a hybrid simulated annealing algorithm," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 639(C).
    14. Soufiane Hayou, 2017. "On the overestimation of the largest eigenvalue of a covariance matrix," Papers 1708.03551, arXiv.org.

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    More about this item

    Keywords

    Covariance matrix; Markovitz optimization; shrinkage; tracking error;
    All these keywords.

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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