Intuitive Portfolio Shrinkage That Even Your Mum Can Understand
For all of you who are degenerates at constructing portfolios
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Welcome back my friends. Today we are taking a break from Ridge Regression. We will talk about a bit about portfolio robustness. If you are familiar with mean-variance optimisation (MVO), you would've heard all the yapping about how MVO is error maximising, non-robust, and much more.
Then there were titans who came back with smart ways to make MVO more robust. One of the more popular ways of doing that is by shrinkage. You can either shrink your expected returns, or your covariance matrix, or both.
But as we will see later, most traditional shrinkage methods have one big issue that is implicit in the methods. The issue is: you don't get to choose the behaviour of the portfolio at the limit. That doesn't sound like a big issue? Well let's go through that together. We will go through examples why that can be problematic.
And of course we will try to remedy that. As as we will see the technique to address this is remarkably simple, which we call it Intuitive Shrinkage. Yes it's super intuitive that even your mum can understand.