The Impact of Expected Return Uncertainty on Long Horizon Risk and Allocation Decisions

Uncertainty in expected return estimates introduces a risk that is small over short periods of time and therefore often ignored. However, it becomes very important over longer horizons, in some circumstances outweighing more conventional risks. This paper demonstrates the effect of incorporating uncertainty in expected returns into an asset allocation process. It shows that the effect of uncertainty increases with the investment horizon. This analysis is extended to active management or hedge fund allocations, where uncertainty is arguably greatest