Black Litterman and Robust Portfolio Optimization

11112012 p kolm 20 robust portfolio optimization main

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Unformatted text preview: P. KOLM. 19 Incorporate Estimation Error in Portfolio Optimization Caveats of classical M-V: o Assumes that expected returns and covariances are known with certainty o Does not take estimation error into account Robust portfolio allocation: o Takes into account uncertainty in expected returns and covariances o Incorporates estimation error into the optimization o Takes about the same time to solve as the classical M-V problem RISK AND PORTFOLIO MANAGEMENT WITH ECONOMETRICS, VER. 11/11/2012. © P. KOLM. 20 Robust Portfolio Optimization: Main Idea Robust portfolio optimization explicitly incorporates estimation error into the portfolio optimization process: max { s.t . w ÎC w min ˆ ˆ m ÎU e ( m ), SÎU d (S) {m¢w } - lw ¢Sw } ˆ ˆ U e (m ), U d (S) : uncertainty sets Uncertainty in expected returns or covariance matrix, or both Two important trade-offs: o Uncertainty sets should be large enough to contain the true (unknown) parameter(s) o Uncertainty sets should be small enough to avoid trivial portfolios (minimum variance, equally weighted, etc.) RISK AND PORTFOLIO MANAGEMENT WITH ECONOMETRICS, VER. 11/11/...
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This document was uploaded on 02/17/2014 for the course COURANT G63.2751.0 at NYU.

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