Portfolio selection revisited

Abstract In 1952, Harry Markowitz formulated portfolio selection as a trade-off between expected, or mean, return and variance. This launched a massive research effort devoted to finding suitable inputs to mean-variance optimization. The estimation problem is high dimensional and a factor model is at the core of many attempts. A factor model can reduce the number of parameters that need to be estimated to a manageable size, but these parameters may incorporate substantial, hidden estimation error. Recent analysis elucidates the nature of this error, identifies a mechanism by which it can corrupt optimization and provides a method for its mitigation. We explore this analysis here by illustrating how to improve the volatility ratio of large optimized portfolios, leading to superior portfolio selection. $$^{*}$$ <mml:math xmlns:mml="http://www.w3.org/1998/Math/MathML"> <mml:mmultiscripts> <mml:mrow/> <mml:mrow/> <mml:mrow> <mml:mrow/> <mml:mo>∗</mml:mo> </mml:mrow> </mml:mmultiscripts> </mml:math>