Incorporating estimation errors into portfolio selection: Robust portfolio construction

Abstract

More than 50 years have elapsed since Markowitz (1952) first introduced his Nobel Prize-winning work on mean-variance portfolio optimisation. His work led to the creation of the field now known as Modern Portfolio Theory (MPT). Throughout this time, MPT has had many followers but has also been challenged by sceptics at academic and financial institutions alike. Today even though MPT is still widely accepted as the primary theoretical framework for portfolio construction, its employment by investment professionals is not as ubiquitous as one might expect. There are several reasons for the lack of acceptance of MPT among practitioners, but perhaps the most significant is the argument that ‘optimal’ portfolios obtained through the mean-variance approach are often ‘counterintuitive’, ‘inexplicable’ and ‘overly sensitive to the input parameters’.