Incorporating Estimation Risk in Portfolio Choice

Abstract

We propose an adjustment in mean-variance portfolio weights to incorporate uncertainty caused by the fact that, in general, we have to use estimated expected returns.The adjustment amounts to using a higher pseudo risk-aversion rather than the actual risk-aversion.The difference between the actual and the pseudo risk-aversion depends on the sample size, the number of assets in the portfolio, and the curvature of the mean-variance frontier.Applying the adjustment to international portfolios, we show that the adjustments are nontrivial for G5 country portfolios and that they are even more important when emerging markets are included.We also show that, in the case of time-varying expected country returns, our adjustment implies a signifficantly smaller variability in portfolio weights than is commonly believed.