A Framework for Asset Allocation in Pakistani Equity Market: Simpler is Better

Abstract

Markowitz (1952) proposes optimal rules for asset allocation in risky assets and assumes that investor should only consider the return and risk of investment while making the asset allocation decisions. This asset allocation process revolves round the estimation of well structured variance-covariance matrix. This study has two main objectives. First, it compares 12 alternative ways for estimating the covariance matrix within four categorize i.e. traditional approach, factor approach, equally weighted portfolio of covariance estimators and shrinkage base covariance matrix in equity market of Pakistan. Secondly, it compares the optimal weights computed by mean-variance framework with weights under the phenomena of non-theory base diversification. On the basis of root mean square error, risk profile of minimum variance portfolios, risk-return characteristics of weights, sharp ratio and Herfindahl index it is empirically concluded that investors and portfolio managers cannot achieve any additional edge by using most sophisticated ways over relatively simple and straight forward ways of estimating the covariance matrix in equity market of Pakistan.