Estimation error in mean returns and the mean-variance efficient frontier

Majeed Simaan, Yusif Simaan, Yi Tang

Research output: Contribution to journalArticlepeer-review

13 Scopus citations

Abstract

In this paper, we build estimation error in mean returns into the mean-variance (MV) portfolio theory under the assumption that returns on individual assets follow a joint normal distribution. We derive the conditional sampling distribution of the MV portfolio along with its mean and risk return when the sample covariance matrix is equal to the population covariance matrix. We use the mean squared error (MSE) to characterize the effects of estimation error in mean returns on the joint sampling distributions and examine how such error affects the risk-return tradeoff of the MV portfolios. We show that the negative effects of error in mean returns on the joint sampling distributions increase with the decision maker's risk tolerance and the number of assets in a portfolio, but decrease with the sample size.

Original languageEnglish
Pages (from-to)109-124
Number of pages16
JournalInternational Review of Economics and Finance
Volume56
DOIs
StatePublished - Jul 2018

Keywords

  • Estimation error
  • Investment
  • Multivariate analysis
  • Portfolio theory

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