Parameter Uncertainty in Multiperiod Portfolio Optimization with Transaction Costs
45 Pages Posted: 16 Jul 2013 Last revised: 28 Feb 2014
Date Written: February 26, 2014
Abstract
We study the impact of parameter uncertainty on the expected utility of a multiperiod investor subject to quadratic transaction costs. We characterize the utility loss associated with ignoring parameter uncertainty, and show that it is equal to the product between the single-period utility loss and another term that captures the effects of the multiperiod mean-variance utility and transaction cost losses. To mitigate the impact of parameter uncertainty, we propose two multiperiod shrinkage portfolios and demonstrate with simulated and empirical datasets that they substantially outperform portfolios that ignore parameter uncertainty, transaction costs, or both.
Keywords: estimation error, shrinkage portfolios, trading costs, out-of-sample performance
JEL Classification: G11
Suggested Citation: Suggested Citation
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