A Bayesian Information Criterion for Portfolio Selection
Computational Statistics & Data Analysis, 2012
The 1952 mean–variance theory of Markowitz indicates that large investment portfolios naturally provide better risk diversification than small ones. However, due to parameter estimation errors, one may find ambiguous results in practice. Hence, it is essential to identify relevant stocks to alleviate the impact of estimation error in portfolio selection.
To this end, Professor Chih-Ling Tsai and co-authors Wei Lan and Hansheng Wang from Peking University propose a linkage condition to link the relevant and irrelevant stock returns via their conditional regression relationship. Subsequently, the authors obtain a BIC selection criterion that enables us to identify relevant stocks consistently. Numerical studies indicate that BIC outperforms commonly used portfolio strategies in the literature.