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

12 June 2009
C. Lindberg
ArXiv (abs)PDFHTML
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 nnn 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/n1/n1/n of the wealth invested in stocks in each of the nnn 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/n1/n1/n strategy.

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