How Should Private Investors Diversify? - An Empirical Evaluation of Alternative Asset Allocation Policies to Construct A World Market Portfolio

Abstract

This study evaluates the out-of-sample performance of numerous asset allocation strategies from the perspective of a Euro zone investor. Besides an increased sample period from January 1973 to December 2008, our contribution to the literature is twofold. First, we compare the performance of a broad spectrum of heuristic portfolio policies with a large set of well-established model extensions of the Markowitz (1952) mean-variance framework. Second, we explicitly differentiate between two prominent ways of diversification that are usually analyzed separately: international diversification in the stock market and diversification over different asset classes. Our analysis allows us to compare and discuss different diversification strategies to construct a "world market portfolio" that is as ex-ante efficient as possible. For international equity diversification, we find that none of the Markowitz-based portfolio models is able to significantly outperform simple heuristics. Among those, the GDP weighting dominates the traditional cap-weighted approach. In the asset allocation case, Markowitz models are again not able to beat a broad spectrum of fixed-weight alternatives out-of-sample. Analyzing more than 5000 heuristics, we find that in fact almost any form of well-balanced allocation over asset classes offers similar diversification gains as even very sophisticated and recently developed portfolio optimization approaches. Based on our findings, we suggest a simple and cost-efficient allocation approach for private investors.

Beyond the Carry Trade: Optimal Currency Portfolios

“…The strategy combining the relevant signals increases the Sharpe ratio relative to an equal-weighted carry portfolio from 0.57 to 0.86, out-ofsample and after transaction costs. This is a 0.29 gain, about the same as the Sharpe 7 DeMiguel, Garlappi, and Uppal (2009), Jacobs, Müller, and Weber (2010). 8 Though an out-of-sample exercise does not eliminate forward looking bias completely.…”

Improving Portfolio Selection Using Option-Implied Volatility and Skewness

“…However, the recent literature on empirical asset pricing (see, e.g., the papers cited in footnote 4) finds that quantities that can be inferred from option prices such as the volatility risk premium and option-implied skewness are useful for predicting returns on stocks. But, it is well known in the literature (see, e.g., DeMiguel, Garlappi, and Uppal (2009), Jacobs et al (2010)) that the weights of the traditional mean-variance portfolio are very sensitive to errors in estimates of expected returns, and that these portfolios perform poorly out of sample. Therefore, when evaluating the benefits of using option-based characteristics to form mean-variance portfolios, we use two alternative approaches.…”

“…For evidence of this poor performance, see, Jacobs, Muller, and Weber (2010), and the references therein.2 These approaches include: imposing a factor structure on returns(Chan, Karceski, and Lakonishok (1999)), using data for daily rather than monthly returns(Jagannathan and Ma (2003)), using Bayesian methods(Jobson, Korkie, and Ratti (1979),Jorion (1986),Pástor (2000), andLedoit and Wolf (2004b)), constraining short sales (Jagannathan and Ma), constraining the norm of the vector of portfolio weights (DeMiguel, Garlappi, Nogales, and Uppal (2009)), and using stock-return characteristics such as size, book-to-market ratio, and momentum to choose parametric portfolios(Brandt, Santa-Clara, and Valkanov (2009)). 3 Jagannathan and Ma ((2003), pp.…”

Adaptive behavior leads to under-diversification

“…The main goal of the current paper is to highlight the role of adaptive behavior in under-diversification. Under-diversification is commonly observed (e.g., Blume & Friend, 1975;Goetzmann and Kumar, 2004;Jacobs, Muller and Weber, 2009;Kelly, 1995;Odean, 1999;Polkovnichenko, 2005;Statman, 1987Statman, , 2004 but contradicts standard portfolio theory since diversification can reduce volatility without reducing expected returns. 1 The reason adaptive behavior, particularly chasing of returns, leads to under-diversification is that a diversified asset (yielding a weighted average of other assets' returns) can never have a greater yield than the maximum of its components.…”