On Portfolio Optimization: Forecasting Covariances and Choosing the Risk Model

Louis K. C. Chan; Jason Karceski; Josef Lakonishok

doi:10.1093/rfs/12.5.937

On Portfolio Optimization: Forecasting Covariances and Choosing the Risk Model

Louis K. C. Chan¹; Jason Karceski^2,3,4; Josef Lakonishok¹

¹ University of Illinois Urbana-Champaign · ² University of Florida Health · ³ Florida College · ⁴ University of Florida

Review of Financial Studies 1999 open access

We evaluate the performance of models for the covariance structure of stock returns, focusing on their use for optimal portfolio selection. We compare the models' forecasts of future covariances and the optimized portfolios' out-of-sample performance. A few factors capture the general covariance structure. Portfolio optimization helps for risk control, and a three-factor model is adequate for selecting the minimum-variance portfolio. Under a tracking error volatility criterion, which is widely used in practice, larger differences emerge across the models. In general more factors are necessary when the objective is to minimize tracking error volatility.

DOI: 10.1093/rfs/12.5.937
Volume: 12 (5)
Pages: 937-974
Language: en
Export: BibTeX
Sources: openalex crossref