2004 · The Journal of Portfolio Management
Honey, I Shrunk the Sample Covariance Matrix
What it asks
As the number of assets approaches the number of observations, the sample covariance matrix becomes unreliable. Instead of using it on its own, Ledoit and Wolf take a weighted average of it with a more constrained estimator. The weight is not arbitrary; it is computed from the data. The resulting matrix carries less noise and can be inverted safely.
What this paper connects to
Answers · 1989
The Markowitz Optimization EnigmaThe sample covariance matrix is unstable; shrinkage pulls it toward a structured estimator and cuts the noise.