Portfolio Choice with Unsystematic Risk
Raman Uppal, EDHEC Business School (with Valentina Raponi, Paolo Zaffaroni)
Abstract:
We develop a normative theory for constructing mean-variance portfolios robust to model misspecification. We identify two inefficent portfolios - an "alpha" portfolio, representing latent asset demand, that depends only on pricing errors and a "beta" portfolio that depends on observed factor risk premia - which, when combined, give mean-variance efficient portfolios. We show that the alpha and beta portfolios have different economic properties and therefore misspecification in these portfolios should be treated using different methods. Our theoretical insights lead to an economically substantial and statistically significant improvement in out-of-sample portfolio performance, with latent assent demand playing a dominant role.