In Defense of Portfolio Optimization: What If We Can Forecast?

Publication Type:
Journal Article
Financial Analysts Journal, 2019, 75 (3), pp. 20 - 38
Issue Date:
Filename Description Size
10.1080 0015198X.2019.1600958.pdfPublished Version814.46 kB
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© 2019, © 2019, CFA Institute. We challenge the academic consensus that estimation error makes mean–variance portfolio strategies inferior to passive equal-weighted approaches. We demonstrate analytically, via simulation, and empirically that investors endowed with modest forecasting ability benefit substantially from a mean–variance approach. An investor with some forecasting ability improves expected utility by increasing the number of assets considered. We frame our study realistically using budget constraints, transaction costs, and out-of-sample testing for a wide range of investments. We derive practical decision rules to choose between passive and mean–variance optimization and generate results consistent with much financial market practice and the original Markowitz formulation.
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