Quote:
Originally Posted by pelagius
I will highlight one.
The strongest assumption of stylized portfolio theory is that an investor knows the expected returns, variances, and covariances of the securities she is invests in. However, this is far from the truth. Estimating these things using historical data is very difficult and imprecise (expected returns more so than covarances). A non-stylized version would incorporate this source of uncertainty. One implication of this uncertainty is that you won't have precise weights as an implication and a range of weights on different securities are all potentially optimal given an investor preferences and parameter uncertainty. This is one reason why BYU71's statements are entirely consistent as opposed to inconsistent with portfolio theory (on the other hand I can write down a form of portfolio theory that was consistent with BYU71s statement and relied on parameter certainty).
The other option is to move beyond portfolio theory to equilibrium models such as the CAPM or APT type models. This is essentially what Jay has done. You get precise implications and solve the estimation issue in terms of portfolio holdings but at the expense of stronger assumptions.
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Thanks for that. On further review, I guess coy works for me.