infonet-economy

A well-known pitfall of Markowitz (1952) portfolio optimization is that the sample covariance matrix, which is a critical input, is very erroneous when there are many assets to choose from. Ifnunchecked, this phenomenon skews the optimizer towards extreme weights that tend to performnpoorly in the real world. One solution that has been proposed is to shrink the sample covariance matrix by pulling its most extreme elements towards more moderate values. An alternative solution is the resampled efficiency suggested by Michaud (1998). This paper compares shrinkagenestimation to resampled e*ciency. In addition, it studies whether the two techniques can bencombined to achieve a further improvement. All this is done in the context of an active port-nfolio manager who aims to outperform a benchmark index and who is evaluated by his realizedninformation ratio.