Bayes-Stein Estimation for Portfolio Analysis Philippe Jorion The Journal of Financial and Quantitative Analysis, Vol. 21, No. 3 (Sep., 1986), 279-292. Stable URL hitp://links jstor-org/sii sici=0022-1090% 28 198609%292 1%3A3%3C279%3A BEFPA%3E2.0,CO%3B2-E, The Journal of Financial and Quantitative Analysis is currently published by University of Washington School of Business Administration ‘Your use of the ISTOR archive indicates your acceptance of JSTOR’s Terms and Conditions of Use, available at hutp:/uk,jstor.org/abouvterms.himl. JSTOR’s Terms and Conditions of Use provides, in part, that unless you have obiained prior permission, you may not download an entire issue of journal or multiple copies oF articles, and you ‘may use content in the JSTOR archive only for your personal, non-commercial use, Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at hupfuk,jstor-org/journals/uwash htm] Each copy of any part of @ JSTOR transmission must contain the same copyright notice that appears on the sereen or printed page of such transmission. STOR is an independent not-for-profit organization dedicated to creating and preserving a digital archive of scholarly journals. For more information regarding JSTOR, please contact support @ jstor.org, hup://uk jstororg/ Mon Feb 7 01:42:20 2005,JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS OL 21,NO. 2. SEPTEMBER 1988 Bayes-Stein Estimation for Portfolio Analysis Philippe Jorion* Abstract In portfolio analysis, uncertainty about parameter values leads to suboptimal portfolio ‘choices. The resulting oss inthe investor's utility isa function of the particular estimator ‘chosen for expected returns. So, this isa problem of simultaneous estimation of normal ‘means under a wel-specified loss function. In this situation, as Stein has shown, the clas- sical sample mean is inadmissible. This paper presents a simple empirial Bayes estimator ‘that should outperform the sample mean in the context of a portfolio. Simulation analysis shows that these Bayes-Stein estimators provide significant gains in portolio selection problems 1. Introduction Inmedio virus One of the fundamental propositions of the modern virtus theory of finance is that security risk has to be considered in the context of a portfolio. It is aston- ishing then that estimation techniques in finance have not recognized the implica- tions ofthis result for efficient estimation of unknown parameters. In the context of a portfolio, using sample means to estimate expected returns amounts to ignor- ing information contained in other series, and could be compared to assessing the risk of a security by looking atthe variance of its return, rather than at its contri- bation to overall portfolio risk. ‘This paper presents an application of shrinkage estimation to portfolio selec- tion problems. Shrinkage estimators have already been used in finance (see [31], (7), and [19)), but always on an ad hoc basis. This paper provides a sound ration- ale for such estimators, and illustrates the extent of possible gains over classical estimators, The application of portfolio analysis & la Markowitz [25] traditionally pro- ceeds in two steps. First, the moments ofthe distribution of returns are estimated from a time-series of historical returns; then the mean variance portfolio selection, problem is solved separately, as if the estimates were the true parameters. This * Graduate Schoo! of Business, Columbia University, New York, NY 10027 This paper drs ‘on part of the author's disseation atthe University of Chicago, and was presented st te 1983 [NBER-NSF Conference on Bayesian Inference in Econometrics The authori graf 10 Armold Zeller for wefl discussions and commen and an anonymous JFQA referee who also helped 10 prove the paper. The reearch was supported by the CollogeInteruniverstsire d Eades Doctors dans les Sciences du Management. 27a280 Journal of Financial and Quantitative Analysis, “certainty equivalence" viewpoint, in which the sample estimates are treated as the true values, has been criticized by Barry(1, Brown (11), and Klein and Bawa [22], who advocate a Bayesian approach that explicitly incorporates estimation error. But their conclusions should be carried further, which is what the present study proposes todo. “The impact of parameter uncertainty on optimal portfolio selection has been recognized by a number of authors (see [17], [13], and (20]) who show that the practical application of portfolio analysis is seriously hampered by estimation error, especially in expected returns. Variances and covariances are also un- known, but are more stable over time, as pointed out by Merton [27]. In this context, the relevant measure of estimation risk isthe utility loss due to a portfolio choice based on sample estimates, rather than on true values. This, loss is a function of the estimator chosen for the population moments. Conse- quently, one should select an estimator with average minimizing properties rela tive o this loss function. Brown (11} provided a Bayesian correction based on a — Fax =F @ Lagt.g = TMX © ap = ET Figure 1 illustrates the utility loss due to estimation risk. Ifthe investor knew the true parameters, he would choose the portfolio represented by point A, where the weights q° are optimal relative to the true frontier (the solid line). Unfortunately, he only observes sample estimates, and selects portfolio B, with composition g, which is optimal relative to the estimated frontier (he dashed line). However, this choice q is suboptimal relative to the erue parameters: for point C, F) = Fax. The difference between these values can be attributed to estimation risk; it eam also be expressed in risk-free equivalent return, by trans- forming te level of expected utility F into a risk-free rate R o F(n,.02) = F(R.) Various estimators §(y) imply various portfolio choices 4(4(y)) and, thus, various losses 1(0,6,9)). This leads to a well-defined loss function for the estimator 6()) viewed as a function 1) of the data: 1. for ty) = 0, the loss is zero, 2. for any 86) # 6 the loss is nonnegative Because the loss is a function of random elements, it cannot be minimizedorion 283 FIGURE 1 Pontotio Choice with Estimation Error as such, In sampling theory, the risk function for an estimator 1() is defined as the expected loss over repeated samples ® 2,@) = [L(@4q)s01 Hay A decision rule to(-) is said to be inadmissible if there exists another rule £,() with at least equal and sometimes lower risk for any value of the true unknown parameter 0. ‘Thus, a reasonable minimum requirement for any estimator is admissibility. ‘The central thesis of this paper is thatthe usual sample mean is not admissible for portfolio estimation, Ill, Stein Estimation Consider the problem of estimating 1, the vector of means of N’ normal random variables, distributed as %~ MDE), = where the covariance matrix is assumed known. For N greater than 2, Efron and Morris [16], generalizing Stein’s (29] result, showed that the maximum-likel ‘hood estimator jayq(), which is also the vector of sample means ¥, is inadmissi ble relative to a quadratic loss function o Le BOD) = = B@)'E'H - BO) ‘The use of this loss function is relatively widespread because it leads to tractable results. It is interesting to study because, in the univariate case, the optimal esti- ‘mator is the sample mean. Also, a quadratic loss is generally a good local ap- proximation of a more general loss function expanded in a Taylor series. For repeated observations, the so-called James-Stein estimator (10) fs) = = WE + WY,264 Journal of Financial and Quantitative Analysis, where wis defined as ay » has uniformly lower risk than the sample mean ¥. This estimator is also called a shrinkage estimator, since the sample means are multiplied by a coefficient (1 — 5) lower than one. Further, the estimator can be shrunk toward any point Yo, and stil have Tower risk than the sample mean, but the gains are greater when Y, is close to the true value. For negative values of (1 ~ 1), setting the coefficient equal to zero leads to an improved estimator: this is the positive part rule. Note that this estimator is biased and nonlinear, since the shrinkage factor is itself a function of the data ‘The superiority of the James-Stein estimator is a startling result. Indeed, statisticians have been slow to recognize this powerful new statistical technique, in spite of Lindley’s [23] early description of it as “‘one of the most important statistical ideas ofthe decade.""? Basically, the result stems from the summation of the components of the Joss function: Stein's estimators achieve uniformly lower risk than the maximum, likelihood estimator, allowing increased risk to some individual components of the vector 2. AS a result, the inadmissibility of the sample mean has been ex- tended by Brown ({8}, (9], and [10)) to other loss functions under surprisingly weak conditions. Unfortunately, proof of inadmissibility does not necessarily lead to the con- struction of better estimators, and the computation of the risk function is an ardu- ‘ous task. Berger [3], however, developed an approach that leads to improved ‘estimators for polynomial loss functions. For a loss function that is the square of the usual quadratic loss, he finds that a shrinkage factor ofthe form (a2) . a+ with 0 =} 4) Bayes-Stein (= wT) 1 = WE + LY, Me KOO] Brown (11] has found the second estimator to be generally superior to the first ‘one. The third estimator, advocated by Jobson et al, [19} i an extreme case of Shrinkage, and has no formal justification in this context because the system is forced tobe stationary. This choice, however, yields a particularly simple porfo- li selection rule: for all uility functions, the optimal weights will be those ofthe ‘minimum variance portfolio, © Retums were generated by the IMSL subroutine GGNSM, All computations were performed indouble- precision FORTRAN,orion 287 TABLE 1 Distribution Parameters forthe Simulation Analysis. ean Covariance Matrix Canada 1287 42.18 France 10962018 70.89 Germany 0.50) 1088 2158 2551 dapan” 1.524 1841 “960 2299 Switzer, 0.763, za 2263 1032 3001 Uk 1858 2380 1322 1048 1695 aa29 us. 0.820 i262 470 «100720980162 World 0.916 Eticiont Set Statistics 0.11898 0.0965, thus Yq = bic = 0805 0.15849 YS" 1%) = 0.08171 (ote: Doar etuns in percent per month. Sample period is January 1877 December ets Dares n percent por marin Sample pedi Janay 1977—Decenbe Inorder to find optimal weights, we had to define the investor’s utility func tion. The negative exponential utility function was chosen here because of the existence of a closed-form solution for the optimal portfolio.” But the results should be robust tothe choice of the utility function. A quadratic utility function gave essentially the same results, which are not reported here. For each drawing &, the optimal portfolio was computed for each possible estimator, leading to different values of the derived expected utility F, = Flgian(y)) | w, 31, fori = 1 to 4. Repeating the experiment K = 1000 indepen- dent times, the empirical risk function was defined as the average loss of ex- pected utility pine, = Fimx= P(E). won 6(Q,09) = Sree) |Faaax| Expected utility was also expressed in risk-free equivalent return, as in (7). Fi- nally, to study the effect of sample size, the previous operations were repeated for various values of T ranging from 25 to 200. Figure 2 depicts the empirical risk functions, also reported in Table 2. Sev- cral features are apparent. First, the Bayes-Stein estimator has always lower risk than both the certainty equivalence and the Bayes diffuse prior estimators. The improvement is noticeable and significant. In risk-free equivalent, the gain over the diffuse prior case ranges from 8 percent (T = 25) to 2 percent (T = 50) to 0.2 percent (T = 200) per annum. The reason behind the superiority of the Bayes-Stein estimator is that the shrinkage factor i is directly derived from the data, For small sample sizes, large values of «indicate that portfolio analysis should not rely too much on the observed dispersion in sample means, given the large coefficients of variation of stock returns. But, of course, as the sample size “The absolute isk aversion was chosen to be 152.2% pa), asia Brown [11] In annual terms, this implies tat percent increase in he variance (10 peoen in standard deviation) ust Be sscompanied by an increase of about | pecent in expected ret,288 Journal of Financial and Quantitative Analysis FIGURE 2 Empidcal Risk Functions TABLE 2 Empirical Risk Functions and Shrinkage Factors Sample Certainty Bayes Minimum —_Shinkage Sue Equvalence Diffuse Prior _Varance Bayes Stein Mean Sto, Dev a 15606 0Hs2 0337 OTIS OS8BS 01568 30 04846 = 0.2204 © 0.11000 13018692 0.1464 0 o2aat 01526 © 00865 00816 © 0s383 1427 50 01578 01137 0.07e2 «= 7e2 S199 0.1386, © o.1108 0.0856 0.0690 «00576 0.5008 0.1365, 50 0.0828 = 0.0683 0.0608 ONS 0.8555 0.1382 109 0.05869 0049300577 00s75 0.4275 (0.1228 125, 0.0430 © 0.0385 «0.0528 «00a ««.a097 | O17 160 003% 00310-00510 00256 ©3504 0.1073, 200 0.0253 0.0236 .ades 0.0205 0.3164 0.0806 "Notas: Negative exponential uty tuncion with absolute risk aversion of 1(S2.2% pa) Maximum expected uy ven te rue parameters 0.99724. increases, so does the estimated precision of sample means, and the shrinkage factor decreases, thus putting less weight on the informative prior relative to the data, Next, the minimum-variance estimator performs well for small. sample sizes, but is dominated for higher sample sizes. This is not astonishing: this strat- egy completely disregards any information contained in the sample means, which produces very good results for small samples, but is otherwise clearly in- appropriate. For higher sample sizes, expected returns are more accurately esti- ‘mated, and utility could be increased by taking into account the expected return of the portfolio. But this estimator would be particularly robust to nonsta- tionarity. Finally, comparisons of the certainty equivalence and Bayes diffuse prior rules confirm the conclusions of Brown's study [11]: the Bayes diffuse prior ‘uniformly dominates the classical rue. ‘Sections III and IV indicated that Bayes-Stein estimation should outperformorion 289 the sample mean, whatever the true parameter values, and the simulation analy- sis indicated thatthe gains were substantial. Surely, these gains must be sensitive to the choice of the “true” parameter values, but it seems that these results pro- vvide conservative estimates of the gains from the Bayes-Stein estimator. Con- sider how different the means are in Table 1: expressed on a per annum basis, they vary from 6 percent to 22 percent. Insofar as this dispersion might be con- sidered unrealistic, the simulation analysis will be biased against Bayes-Stein estimation. To take the case even further, the analysis was repeated with the hhighest mean changed from 22 percent to 44 percent per annum. The gains from shrinkage estimation were, on average, cut in half, but the Bayes-Stein estimator still uniformly dominated the sample mean. VI. Conclusions This paper studied the effect of estimation error on portfolio choice. Since parameter uncertainty implies a loss of investor utility, decision theory should be based on this loss viewed as a function of the estimator and of the true parameter values. A fundamental result of statistical theory is that the sample mean is an inadmissible estimator when the number of parameters is greater than two. (There exists another estimator that always yields lower expected loss in repeated ‘samples.) This result stems from the summation of the effect of estimation error for each component into one single loss measure. Thus, the portfolio context is central to this result. The issue was also analyzed in an empirical Bayes frame- work, and this paper presented a simple Bayes-Stein estimator that should im- prove on the classical sample mean. Next, the extent of gains from Bayes-Stein estimation was illustrated by simulation analysis. The classical rule was always ‘outperformed, and the gains were often substantial, in the range ofa few percent perannum in risk-free equivalent return, ‘Numerous other applications of this technique are possible in finance. For instance, extensions to improved estimation of beta coefficients are straightfor- ward. Also, Jorion [21] evaluated the out-of-sample performance of various esti- ‘ators, based on actual stock return data, and found that shrinkage estimators significantly outperform the classical sample mean. Appendix Bayes-Stein Estimation ‘The problem is to find, asin Zeliner and Chetty [33], the predictive distribu- tion of future returns r, conditional on the prior (13), the data y = (1, Yes ‘on the covariance matrix 3 and on the scale factor \ A pel Ea) = f focnenl x2 .adudn290 Journal of Financial and Quantitative Analysis, ‘When necessary, ¥ and ) will be estimated from the conditional distribution. The joint density ofr, wand is given by Pema | yA) = pc] mem E.A) + PU | YEA) + PEL BE) mE )PCH | aA) With normaly te ketnodfucin oy sven andi (-2)2"@- a]. ‘and the density function of ., given and A, is given by the informative prior (a2 ALE) + evo [(- (3) pw WAX) + o[(-Za- apr! - aD] Here, the A parameter is @ measure of the tightness of the prior; for A tending to zero, the prior tends to a diffuse prior. The parameter 9 represents the unknown ‘grand mean, which is given a diffuse prior. Instead of an informative prior on a ‘model with constant means 2, (A.3) could also represent a mode! where the ‘means vary randomly around a common grand mean The predictive density function can then be written as t pean x2) + exp[(-3)oc.m.n.n]. win -w+ Se- x5" - 2) +@- ab re" ad G=c-wr'e After integration over 9 and tthe predictive density can be shown to be normal ‘with mean vector and covariance matrix as follows (a4) Flr] = A= w)¥+wlh, ww = shrinkage factor weMT +2), Y= vector of sample means: Y= AD Tyo Yo = grand mean Y=! Y= weights ofmin. var. portfolio: x = 13 -M('S 4) 1 a 1 as) viel = (+735) tree TE Ty This covariance matrix has the following interpretation. The fist term ¥ repre- sents the variation of y, around the mean j. The second term 3:(T' + 2) is due to the uncertainty in the measure of the sample average ¥, whereas the third term corresponds to uncertainty inthe common factor.orion 291 For T large, w tends to zero, r tends to ¥, and V tends to ¥. There is no estimation risk, and the sample means are accurate estimates of the expected returns. Similarly, for d very small, w tends to zero, Elz] to ¥, and V to 2 + (UD). Bayes-Stein estimation is useless here, and estimation risk, due to im- precise knowledge of expected return, is impounded on V the usual way. In contrast, for very large values of h, w tends to one, Elz] to 1 Yp, and V to + (VD) LVL’ 3! D Estimation of the means can be based only on the ‘common weighted average Yq, and the matrix added to ¥ reflects uncertainty in this common mean, References U1) Bary, B. “Ponfolio Analysis under Uncertain Means, Variances and Covariance.” Jou nal of Finance, 29 (May 1974), 15-822. [2], Bawa, V. .:5. J. Brown; and R. W. Klin. Estimation Risk and Optimal Porolio Choice “Amsterdam: Noah Holland (1979), [31 Berger, J “Minimax Estimation of a Multivariate Normal Mean under Polynomial Loss, Journal of Mulivariue Analysis, 8 June 1978), 173-180, (8), —___—. staustica! Decision Theory. 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