Return Prediction for Mean-Variance Portfolio Selection: How Decision-Focused Learning Shapes Forecasting Models

Markowitz laid the foundation of portfolio theory through the mean-variance optimization (MVO) framework. However, the effectiveness of MVO is contingent on the precise estimation of expected returns, variances, and covariances of asset returns, which are typically uncertain. Machine learning models are becoming useful in estimating uncertain parameters, and such models are trained to minimize prediction errors, such as mean squared errors (MSE), which treat prediction errors uniformly across assets. Recent studies have pointed out that this approach would lead to suboptimal decisions and proposed Decision-Focused Learning (DFL) as a solution, integrating prediction and optimization to improve decision-making outcomes. While studies have shown DFL's potential to enhance portfolio performance, the detailed mechanisms of how DFL modifies prediction models for MVO remain unexplored. This study investigates how DFL adjusts stock return prediction models to optimize decisions in MVO. Theoretically, we show that DFL's gradient can be interpreted as tilting the MSE-based prediction errors by the inverse covariance matrix, effectively incorporating inter-asset correlations into the learning process, while MSE treats each asset's error independently. This tilting mechanism leads to systematic prediction biases where DFL overestimates returns for assets included in portfolios while underestimating excluded assets. Our findings reveal why DFL achieves superior portfolio performance despite higher prediction errors. The strategic biases are features, not flaws.