English

Factor Dimensionality and the Bias-Variance Tradeoff in Diffusion Portfolio Models

Computational Engineering, Finance, and Science 2026-03-12 v1

Abstract

In this paper, we implement and evaluate a conditional diffusion model for asset return prediction and portfolio construction on large-scale equity data. Our method models the full distribution of future returns conditioned on firm characteristics (i.e.\ factors), using the resulting conditional moments to construct portfolios. We observe a clear bias--variance tradeoff: models conditioned on too few factors underfit and produce overly diversified portfolios, while models conditioned on too many factors overfit, resulting in unstable and highly concentrated allocations with poor out-of-sample performance. Through an ablation over factor dimensionality, we reveal an intermediate number of factors that achieves the best generalization and outperforms baseline portfolio strategies.

Cite

@article{arxiv.2603.10385,
  title  = {Factor Dimensionality and the Bias-Variance Tradeoff in Diffusion Portfolio Models},
  author = {Avi Bagchi and Michael Tesfaye and Om Shastri},
  journal= {arXiv preprint arXiv:2603.10385},
  year   = {2026}
}
R2 v1 2026-07-01T11:14:06.052Z