incorporating estimation errors into portfolio selection.pdfVIP

Incorporating estimation errors into portfolio selection: Robust portfolio construction Received: 17th May, 2006 Sebastia´ n Ceria* is President and CEO of Axioma, Inc., a New York-based company that produces portfolio construction analytics. Before founding Axioma, he was an associate professor of decision, risk and operations at Columbia Business School from 1993 to 1998. He completed his PhD in Operations Research at Carnegie Mellon University’s Graduate School of Industrial Administation. Robert A. Stubbs is Director of Research and Development, for Axioma, Inc., where he develops specialised optimisation solution techniques for financial problems and improved portfolio management methodologies and software. He earned a PhD in Industrial Engineering and Management Science and a Master of Science degree in Industrial Engineering and Management Science from Northwestern University, and a Bachelor of Science degree in Applied Mathmetics from Auburn University. *Axioma. Inc., 100 5th Avenue, Suite 901, New York, NY 10011, USA Tel: +1 (212) 901 1000, Fax: +1 (212) 901 1911; e-mail: sceria@ Abstract The authors explore the negative effect that estimation error has on mean-variance optimal portfolios. It is shown that asset weights in mean-variance optimal portfolios are very sensitive to slight changes in input parameters. This instability is magnified by the presence of constrains that asset managers typically impose on their portfolios. The authors propose to use robust mean variance, a new technique which is based on robust optimisation, a deterministic framework designed to explicitly consider parameter uncertainty in optimisation problems. Alternative uncertainty regions that create a less conservative robust problem are introduced. In fact, the authors’ proposed approach does not assume that all estimation errors will negatively affect the portfolios, as is the case in traditional robust optimisation, but rather that there are as ma