Paper #586

Title:

Improved estimation of the covariance matrix of stock returns with an application to portofolio selection

Authors:

Olivier Ledoit and Michael Wolf

Date:

November 2001

Abstract:

This paper proposes to estimate the covariance matrix of stock returns by an optimally weighted average of two existing estimators: the sample covariance matrix and single-index covariance matrix. This method is generally known as shrinkage, and it is standard in decision theory and in empirical Bayesian statistics. Our shrinkage estimator can be seen as a way to account for extra-market covariance without having to specify an arbitrary multi-factor structure. For NYSE and AMEX stock returns from 1972 to 1995, it can be used to select portfolios with significantly lower out-of-sample variance than a set of existing estimators, including multi-factor models.

Keywords:

Covariance matrix estimation, factor models, portofolio selection, shrinkage

JEL codes:

C13, C51, C61, G11, G15

Area of Research:

Finance and Accounting

Published in:

Journal of Empirical Finance 10, 603-621, 2003

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