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The Attenuation of Idiosyncratic Risk under Alternative Portfolio Weighting Strategies: Recent Evidence from the UK Equity Market

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  • Chia, Rui Ming Daryl
  • Lim, Kai Jie Shawn

Abstract

In this study, we investigate the attenuation of idiosyncratic risk and corresponding benefits of diversification for equally weighted and market capitalisation weighted portfolios in the UK Equity Market over 2002 - 2012. We analyse the absolute benefits of risk reduction by testing the homogeneity of variances of portfolios of different sizes using Levene's Test. Next, we perform a cost-benefit analysis to determine the return benefit of diversification from a practical perspective. We find that the absolute benefits of diversification for an equally weighted portfolio are greater in the 'crisis' than 'pre-crisis' period, but when we analyse the results from a practical perspective the benefits fall dramatically and the results are reversed. When comparing the benefits of market capitalisation weighted and equally weighted portfolios, we note that the benefits of diversification tend to be greater for an equally weighted portfolio for small portfolios but that a crossover occurs as the size of the portfolio increases. The relative benefits of diversification under these different weighting strategies are thus highly dependent upon the state of the market and further study is needed to determine why the diversification benefits for the alternative weighting strategies decay at varying rates.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 41455.

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Date of creation: 21 Sep 2012
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Handle: RePEc:pra:mprapa:41455

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Keywords: Portfolio diversification; idiosyncratic risk; index funds; weighting methodology;

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  1. Erik Hjalmarsson & Peter Manchev, 2009. "Characteristic-based mean-variance portfolio choice," International Finance Discussion Papers 981, Board of Governors of the Federal Reserve System (U.S.).
  2. Elton, Edwin J & Gruber, Martin J, 1977. "Risk Reduction and Portfolio Size: An Analytical Solution," The Journal of Business, University of Chicago Press, vol. 50(4), pages 415-37, October.
  3. Ron Bird & Mark Tippett, 1986. "Note---Naive Diversification and Portfolio Risk---A Note," Management Science, INFORMS, vol. 32(2), pages 244-251, February.
  4. Statman, Meir, 1987. "How Many Stocks Make a Diversified Portfolio?," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 22(03), pages 353-363, September.
  5. Lim, Tjen-Sien & Loh, Wei-Yin, 1996. "A comparison of tests of equality of variances," Computational Statistics & Data Analysis, Elsevier, vol. 22(3), pages 287-301, July.
  6. Abhyankar, Abhay & Ho, Keng-Yu, 2007. "Long-horizon event studies and event firm portfolio weights: Evidence from U.K. rights issues re-visited," International Review of Financial Analysis, Elsevier, vol. 16(1), pages 61-80.
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