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Incorporating Economic Objectives into Bayesian Priors: Portfolio Choice under Parameter Uncertainty

Published online by Cambridge University Press:  08 June 2010

Jun Tu  and
Guofu Zhou
Jun Tu
Affiliation:
Lee Kong Chian School of Business, Singapore Management University, 50 Stamford Rd., Singapore 178899. tujun@smu.edu.sg
Guofu Zhou
Affiliation:
Olin School of Business, Washington University in St. Louis, 1 Brookings Dr., St. Louis, MO 63130. zhou@wustl.edu
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Abstract

This paper proposes a way to allow Bayesian priors to reflect the objectives of an economic problem. That is, we impose priors on the solution to the problem rather than on the primitive parameters whose implied priors can be backed out from the Euler equation. Using monthly returns on the Fama-French 25 size and book-to-market portfolios and their 3 factors from January 1965 to December 2004, we find that investment performances under the objective-based priors can be significantly different from those under alternative priors, with differences in terms of annual certainty-equivalent returns greater than 10% in many cases. In terms of an out-of-sample loss function measure, portfolio strategies based on the objective-based priors can substantially outperform both strategies under alternative priors and some of the best strategies developed in the classical framework.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 45 , Issue 4 , August 2010 , pp. 959 - 986
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2010

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