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

摘要

Bayesian priors on model parameters often ignore the economic objectives at hand. This paper shows that this can be suboptimal, and proposes a way to allow priors to reflect the objective of maximizing an expected utility. Using monthly returns of the Fama-French 25 assets and their three factors from January 1965 to December 2004, we find that the objective-based priors out-perform alternative priors substantially, with annual certainty- equivalent gains of over 10% in many cases. The better performance is present even in repeated sampling experiments, suggesting that objective-based Bayesian optimal portfolios are superior decision rules even judged by the classical statistical criterion.