Estimation Risk in the Portfolio Selection Model

The approach of selecting a portfolio of stocks on the basis of expected return and variance was introduced by Markowitz [18] in 1952 and subsequently was more fully developed by him [19] in 1959. Since this time, there has been considerable research either directly concerned with, or related to, the Markowitz model. The utility implications of his assumption that an investor chooses a portfolio solely on the basis of expected return and variance (where variance is identified with risk) have been studied, [1], [A], [22], and [31]. A simplified method of solving for the efficient set of portfolios under the assumption of a regression structure has been developed by Sharpe [26], and approximation methods have been suggested [25] and [29]. Empirical tests (with partially contradictory conclusions) of portfolio selection theory are described in [5], [7], [8], [20], and [27]. Studies of economic questions (such as liquidity preference, equilibrium stock prices, substitutability of risky assets, etc.), as formulated within the portfolio model, can be found in [10], [11], [13], [14], [16], [23], and [28]. A related portfolio selection approach, based on the assumption of a Pareto underlying distribution, has been suggested by Fama [6]. A modification by Baumol [2] introduced a confidence limit criterion. Also, some initial attempts have been made at deriving related adaptive models of portfolio selection, [21], [30].