Risk Preferences and Estimation Risk in Portfolio Choice

This paper analyzes the estimation risk of efficient portfolio selection. We use the concept of certainty equivalent as the basis for a well-defined statistical loss function and a monetary measure to assess estimation risk. For given risk preferences we provide analytical results for different sources of estimation risk such as sample size, dimension of the portfolio choice problem and correlation structure of the return process. Our results show that theoretically sub-optimal portfolio choice strategies turn out to be superior once estimation risk is taken into account. Since estimation risk crucially depends on risk preferences, the choice of the estimator for a given portfolio strategy becomes endogenous. We show that a shrinkage approach accounting for estimation risk in both, mean and covariance of the return vector, is generally superior to simple theoretically suboptimal strategies. Moreover, focusing on just one source of estimation risk, e.g. risk reduction in covariance estimation, can lead to suboptimal portfolios.