Uncertainty in Second Moments: Implications for Portfolio Allocation

David Daewhan Cho

No 433, Econometric Society 2004 Far Eastern Meetings from Econometric Society

Abstract: This paper investigates the uncertainty in variance and covariance of asset returns. It is commonly believed that these second moments can be estimated very accurately. However, time varying volatility and nonnormality of asset returns can lead to imprecise variance estimates. Using CRSP value weighted monthly returns from 1926 to 2001, this paper shows that the variance is less accurately estimated than the expected return. In addition, a mean variance investor will incur significant certainty equivalent loss due to the uncertainty in second moments. Applying the Fama French 3 factor model to 25 size, BE/ME sorted portfolios from 1963 to 2001, the loss due to the variance estimation can be shown to be as large as the loss due to the expected return estimation. Moreover, as the number of assets in the portfolio increases, the loss due to the variance uncertainty becomes larger. This provides a possible explanation to the home bias puzzle.

Keywords: estimation risk; time varying volatility; bayesian analysis; kurtosis (search for similar items in EconPapers)
JEL-codes: C22 D81 G11 (search for similar items in EconPapers)
Date: 2004-08-11
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
http://repec.org/esFEAM04/up.4255.1073936373.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:ecm:feam04:433

Access Statistics for this paper

More papers in Econometric Society 2004 Far Eastern Meetings from Econometric Society Contact information at EDIRC.
Bibliographic data for series maintained by Christopher F. Baum ().