214 ROBUST PARAMETER ESTIMATION
Incorporating Uncertainty in the Inputs Into the
Portfolio Allocation Process
In the classical mean-variance optimization problem, the expected returns
and che covariance matrix of returns are uncertain and have to be estimated.
After che estimation at these quantities, the portfolio optimisation problem
is solved as a deterministic problem—completely ignoring the uncertainty in
the inputs. However, it makes sense for the uncertainty of expected returns
and risk to enter into the optimization process, thus creating a more realistic
model. Using point estimates of the expected returns and the covariance
matrix of returns, and treating them as error-free in portfolio allocation,
does not necessarily correspond to prudent investor behavior.
The investor would probably be more comfortable choosing a portfo-
lio that would perform well under a number of different scenarios,
thereby also attaining some protection from estimation risk and model
risk. Obviously, to have some insurance in the event of less likely but-
more extreme cases (e.g., scenarios that are highly unlikely under the
assumption that returns are normally distributed), the investor must be
willing to give up some of the upside that would result under the more
likely scenarios. Such an investor seeks a "robust" portfolio, that is, a
portfolio that is assured against some worst-case model misspecification.
The estimation process can be improved through robust statistical tech-
niques such as shrinkage and Bayesian estimators discussed later in this
chapter. However, jointly considering estimation tisk and model risk in
the financial decision-making process is becoming more important.
The estimation process frequently does not deliver a point forecast
(that is, one single number), but a full distribution of expected returns.
Recent approaches attempt to integrate estimation risk into the mean-vari-
ance framework by using the expected return distribution in the optimiza-
tion. A simple approach is to sample from the return distribution and
average the resulting portfolios (Monte Carlo approach). However, as a
mean-variance problem has to be solved for each draw, this is computa-
tionally intensive for larger portfolios. In addition, the averaging does not
guarantee that che resulting portfolio weights will satisfy all constraints.
Introduced in the late 1990s by Ben-Tal and Nemirovski 12 and El
Ghaoui and Lebret, 1 3 the robust optimization framework is computa-
12
Aharon Ben-Tal and Arkadi S. Nemirovski, "Robust Convex Optimization,"
Mathematics of Operations Research 23, no. 4 (1998), pp. 769-805; and Aharon
Ben-Tal and Arkadi S. Nemirovski, "Robust Solutions to Uncertain Linear Pro
grams," Operations Research Letters 25, no. 1 (1999), pp. 1-13.
13
Laurent El Ghaoui and Herve Lebret, "Robust Solutions to Least-Squares Prob
lems with Uncertain Data," SI AM Journal Matrix Analysis with Applications 18, no.
4 (1997), pp. 1035-1064.
Robust Frameworks for Estimation
tionally more efficient than the Monte Carlo approach. This develop-
ment in optimization technology allows for efficiently solving the robust
version of the mean-variance optimization problem in about the same
time as the classical mean-variance optimization problem. The technique
explicitly uses the distribution from the estimation process to iind a
robust portfolio in one single optimization. It thereby incorporates
uncertainties of inputs into a deterministic framework. The classical
portfolio optimization formulations such as the mean-variance portfolio
selection problem, rhe maximum Sharpe ratio portfolio problem, and the
value-at-risk (VaR) portfolio problem all have robust counterparts that
can be solved in roaghly the same amount of time as the original prob-
lem. 14 We describe Monte Carlo simulation techniques in Chapter 12,
and the robust optimization frameworks in Chapters 10, 12, and 13.
Large Data RequiremRnts
In classical mean-variance optimization, we need to provide estimates of"
the expected returns and covariances of all the securities in the invest-
ment universe considered. Typically, however, portfolio managers have
reliable return forecasts for only a small subset of these assets. This is
probably one of the major reasons why the mean-variance framework
has not been adopted by practitioners in general. It is simply unreason-
able for the portfolio manager to produce good estimates of all the
inputs required in classical portfolio theory.
We will see later in this chapter that the Black-Litterman model pro-
vides a remedy in that it "blends" any views (this could be a forecast on
just one or a few securities, or ail them) the investor might have with the
market equilibrium. When no views are present, the resulting Black-Litter-
man expected returns are just the expected returns consistent with the
market equilibrium. Conversely, when the investor has views on some of
the assets, the resulting expected returns deviate from market equilibrium.
SHRINKAGE ESTIMATION
It is well known since Stein's seminal work that biased estimators often
yield better parameter estimates than their generally preferred unbiased
counterparts. 1 5 In particular, it can be shown that if we consider the
14
See, for example, Donald Goidfarb and Garud Iyengar, "Robust Portfolio Selection
Problems," Mathematics of Operations Research 28, no.. 1 (February 2003), pp. 1-38.
15
Charles Stein, "Inadmissibility of the Usual Estimator for the Mean of Multivan-
ate Normal Distribution," Proceedings of the Third Berkeley Symposium on Math
ematical Statistics and Probability 1 (1956), pp. 197-206.