MASSAGING MEAN-VARIANCE INPUTS - RETURNS FROM ALTERNATIVE GLOBAL INVESTMENT STRATEGIES IN THE 1980S

This paper explores the impact of adjustments to the inputs on total r eturns, terminal wealth, and portfolio turnover in an unconstrained mo nthly mean-variance (MV) asset allocation over time. It is well known that MV allocations are very sensitive to small forecast errors in the means and covariances. This sensitivity is especially pronounced for errors in means. One way to control this sensitivity to forecast error s is to use Stein estimation. We examined three naive applications of Stein estimation for six individual country stock indexes, five countr y bond indexes and five cash indexes. This study has two major conclus ions. First, any of the suggested adjustments to inputs dominate the r esults of an unadjusted-input MV optimization. Adjusted-input portfoli os have higher mean return, less variance and greater terminal wealth than unadjusted-input portfolios. Second, these improvements become ev en greater with transaction costs.