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Honey, I Shrunk the Sample Covariance Matrix
Open accessAbstract
The central message of this article is that no one should use the sample covariance matrix for portfolio optimization. It is subject to estimation error of the kind most likely to perturb a mean-variance optimizer. Instead, a matrix can be obtained from the sample covariance matrix through a transformation called shrinkage. This tends to pull the most extreme coefficients toward more central values, systematically reducing estimation error when it matters most. Statistically, the challenge is to know the optimal shrinkage intensity. Shrinkage reduces portfolio tracking error relative to a benchmark index, and substantially raises the manager's realized information ratio.
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Citations
Cites
A well-conditioned estimator for large-dimensional covariance matrices
Ledoit, O., & Wolf, M. (2004) · Journal of Multivariate Analysis · doi:10.1016/s0047-259x(03)00096-4 · Cited by 3,046
Self-citation
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DeMiguel, V., Garlappi, L., & Uppal, R. (2009) · Review of Financial Studies · doi:10.1093/rfs/hhm075 · Cited by 3,199
Chapter 4 Forecast Combinations
Timmermann, A. (2006) · Handbook of Economic Forecasting · doi:10.1016/s1574-0706(05)01004-9 · Cited by 1,314
Consolidation alters motor sequence-specific distributed representations
Pinsard, B., Boutin, A., Gabitov, E., Lungu, O., Benali, H., & Doyon, J. (2019) · eLife · doi:10.7554/elife.39324 · Cited by 1,066
60 Years of portfolio optimization: Practical challenges and current trends
Kolm, P. N., Tütüncü, R., & Fabozzi, F. J. (2014) · European Journal of Operational Research · doi:10.1016/j.ejor.2013.10.060 · Cited by 632
Shrinkage Algorithms for MMSE Covariance Estimation
Chen, Y., Wiesel, A., Eldar, Y. C., & Hero, A. O. (2010) · IEEE Transactions on Signal Processing · doi:10.1109/tsp.2010.2053029 · Cited by 567
Metadata
- Authors
- Ledoit, O., & Wolf, M.
- Venue
- The Journal of Portfolio Management
- Publisher
- With Intelligence LLC
- Published
- 2004-07-31
- Volume
- 30
- Issue
- 4
- Pages
- 110-119
- ISSN
- 0095-4918 (ISSN-L)
- 2168-8656
- OpenAlex
- W3124027709
- Cited by
- 1,266
- References
- 1
- FWCI
- 23.58
- Type
- journal article
- Language
- en
- Open access
- green
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Contains information from the Semantic Scholar Academic Graph Datasets, made available under the ODC Attribution License (ODC-BY 1.0).
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