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Review of Financial Studies Vol. 12 No. 5 1999

On Portfolio Optimization: Forecasting Covariances and Choosing the Risk Model

Louis K. C. Chan1; Jason Karceski2,3,4; Josef Lakonishok1

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

open access

Abstract

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
Issue
5
Pages
937-974
Language
en
Sources
openalex crossref

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