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arXiv · 0908.2455

Second Order Risk

Peter G. Shepard
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Abstract

Managing a portfolio to a risk model can tilt the portfolio toward weaknesses of the model. As a result, the optimized portfolio acquires downside exposure to uncertainty in the model itself, what we call "second order risk." We propose a risk measure that accounts for this bias. Studies of real portfolios, in asset-by-asset and factor model contexts, demonstrate that second order risk contributes significantly to realized volatility, and that the proposed measure accurately forecasts the out-of-sample behavior of optimized portfolios.

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Peter G. Shepard. 2009-08-17. Second Order Risk. https://arxiv.org/abs/0908.2455

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