The Effect of value Estimation Errors On Portfolio Growth Rates

Abstract

This article analyzes the impact of value estimation errors on portfolios’ growth rates and relative growth rates for several portfolio weighting methods. In contrast to previous articles, this one addresses the effect of estimation errors on portfolio growth rates due to increased return volatility. The portfolio weighting methods examined include capitalization weights, estimation error independent weights, Fundamental weights, and Diversity weights. The article provides theoretical support, in the context of estimation error, for the empirical findings that many non-capitalization weighted portfolios’ returns beat the market’s capitalization-weighted portfolio return over time. It also provides a theory for the size effect.

TOPICS: Portfolio management/multi-asset allocation, portfolio theory, volatility measures