The Attenuation of Idiosyncratic Risk under Alternative Portfolio Weighting Strategies: Recent Evidence from the UK Equity Market
AbstractIn 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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Bibliographic InfoPaper provided by University Library of Munich, Germany in its series MPRA Paper with number 41455.
Date of creation: 21 Sep 2012
Date of revision:
Portfolio diversification; idiosyncratic risk; index funds; weighting methodology;
Find related papers by JEL classification:
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
- G01 - Financial Economics - - General - - - Financial Crises
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-10-06 (All new papers)
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