IDEAS home Printed from https://ideas.repec.org/a/eee/finana/v20y2011i5p375-385.html
   My bibliography  Save this article

Do optimal diversification strategies outperform the 1/N strategy in U.K. stock returns?

Author

Listed:
  • Fletcher, Jonathan

Abstract

This paper examines whether optimal diversification strategies outperform the 1/N strategy in U.K. stock returns. The study focuses on the performance of recent strategies developed by Tu and Zhou (2011) and Kirby and Ostdiek (2010). I find that a number of optimal asset allocation strategies can significantly outperform the 1/N strategy even after adjusting for trading costs. The strategies developed by Kirby and Ostdiek outperform the 1/N strategy, even at higher trading costs, due to the low turnover of these strategies. The strategies of Tu and Zhou have mixed performance after adjusting for trading costs due to the high turnover of these strategies. The results of the paper provide support for the use of optimal diversification strategies.

Suggested Citation

  • Fletcher, Jonathan, 2011. "Do optimal diversification strategies outperform the 1/N strategy in U.K. stock returns?," International Review of Financial Analysis, Elsevier, vol. 20(5), pages 375-385.
  • Handle: RePEc:eee:finana:v:20:y:2011:i:5:p:375-385
    DOI: 10.1016/j.irfa.2011.07.002
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S1057521911000809
    Download Restriction: Full text for ScienceDirect subscribers only

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Jorion, Philippe, 1986. "Bayes-Stein Estimation for Portfolio Analysis," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 21(03), pages 279-292, September.
    2. Tu, Jun & Zhou, Guofu, 2011. "Markowitz meets Talmud: A combination of sophisticated and naive diversification strategies," Journal of Financial Economics, Elsevier, vol. 99(1), pages 204-215, January.
    3. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-1054, July.
    4. Massimo Guidolin & Allan Timmermann, 2005. "Economic Implications of Bull and Bear Regimes in UK Stock and Bond Returns," Economic Journal, Royal Economic Society, vol. 115(500), pages 111-143, January.
    5. Zhenyu Wang, 2005. "A Shrinkage Approach to Model Uncertainty and Asset Allocation," Review of Financial Studies, Society for Financial Studies, vol. 18(2), pages 673-705.
    6. Michael C. Jensen, 1968. "The Performance Of Mutual Funds In The Period 1945–1964," Journal of Finance, American Finance Association, vol. 23(2), pages 389-416, May.
    7. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, March.
    8. Whitney K. Newey & Kenneth D. West, 1994. "Automatic Lag Selection in Covariance Matrix Estimation," Review of Economic Studies, Oxford University Press, vol. 61(4), pages 631-653.
    9. Victor DeMiguel & Lorenzo Garlappi & Raman Uppal, 2009. "Optimal Versus Naive Diversification: How Inefficient is the 1-N Portfolio Strategy?," Review of Financial Studies, Society for Financial Studies, vol. 22(5), pages 1915-1953, May.
    10. Greg Anderson & Jonathan Fletcher & Andrew Marshall, 2011. "Performance evaluation of dynamic trading strategies in UK stock returns incorporating lagged conditioning information," The European Journal of Finance, Taylor & Francis Journals, vol. 17(1), pages 67-82.
    11. Ledoit, Olivier & Wolf, Michael, 2003. "Improved estimation of the covariance matrix of stock returns with an application to portfolio selection," Journal of Empirical Finance, Elsevier, vol. 10(5), pages 603-621, December.
    12. Ledoit, Oliver & Wolf, Michael, 2008. "Robust performance hypothesis testing with the Sharpe ratio," Journal of Empirical Finance, Elsevier, vol. 15(5), pages 850-859, December.
    13. Louis K.C. Chan & Jason Karceski & Josef Lakonishok, 1999. "On Portfolio Optimization: Forecasting Covariances and Choosing the Risk Model," NBER Working Papers 7039, National Bureau of Economic Research, Inc.
    14. MacKinlay, A Craig & Pastor, Lubos, 2000. "Asset Pricing Models: Implications for Expected Returns and Portfolio Selection," Review of Financial Studies, Society for Financial Studies, vol. 13(4), pages 883-916.
    15. Ravi Jagannathan & Tongshu Ma, 2003. "Risk Reduction in Large Portfolios: Why Imposing the Wrong Constraints Helps," Journal of Finance, American Finance Association, vol. 58(4), pages 1651-1684, August.
    16. Pastor, Lubos & Stambaugh, Robert F., 2000. "Comparing asset pricing models: an investment perspective," Journal of Financial Economics, Elsevier, vol. 56(3), pages 335-381, June.
    17. Fletcher, Jonathan & Hillier, Joe, 2002. "On the usefulness of linear factor models in predicting expected returns in mean-variance analysis," International Review of Financial Analysis, Elsevier, vol. 11(4), pages 449-466.
    18. Grauer, Robert R & Hakansson, Nils H, 1986. "A Half Century of Returns on Levered and Unlevered Portfolios of Stocks, Bonds, and Bills, with and without Small Stocks," The Journal of Business, University of Chicago Press, vol. 59(2), pages 287-318, April.
    19. Weimin Liu & Norman Strong, 2008. "Biases in Decomposing Holding-Period Portfolio Returns," Review of Financial Studies, Society for Financial Studies, vol. 21(5), pages 2243-2274, September.
    20. Fletcher, Jonathan, 1997. "An Investigation of Alternative Estimators of Expected Returns in Mean-Variance Analysis," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 20(1), pages 129-143, Spring.
    21. repec:bla:jfnres:v:20:y:1997:i:1:p:129-143 is not listed on IDEAS
    22. Lubos Pástor, 2000. "Portfolio Selection and Asset Pricing Models," Journal of Finance, American Finance Association, vol. 55(1), pages 179-223, February.
    23. Jeff Fleming, 2001. "The Economic Value of Volatility Timing," Journal of Finance, American Finance Association, vol. 56(1), pages 329-352, February.
    24. Frost, Peter A. & Savarino, James E., 1986. "An Empirical Bayes Approach to Efficient Portfolio Selection," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 21(03), pages 293-305, September.
    25. Wayne E. Ferson & Andrew F. Siegel, 2009. "Testing Portfolio Efficiency with Conditioning Information," Review of Financial Studies, Society for Financial Studies, vol. 22(7), pages 2535-2558, July.
    26. Kan, Raymond & Zhou, Guofu, 2007. "Optimal Portfolio Choice with Parameter Uncertainty," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 42(03), pages 621-656, September.
    27. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
    28. Victor DeMiguel & Lorenzo Garlappi & Francisco J. Nogales & Raman Uppal, 2009. "A Generalized Approach to Portfolio Optimization: Improving Performance by Constraining Portfolio Norms," Management Science, INFORMS, vol. 55(5), pages 798-812, May.
    29. Best, Michael J. & Grauer, Robert R., 1992. "The analytics of sensitivity analysis for mean-variance portfolio problems," International Review of Financial Analysis, Elsevier, vol. 1(1), pages 17-37.
    30. Grauer, Robert R. & Hakansson, Nils H., 1995. "Stein and CAPM estimators of the means in asset allocation," International Review of Financial Analysis, Elsevier, vol. 4(1), pages 35-66.
    31. Solnik, Bruno, 1993. "The performance of international asset allocation strategies using conditioning information," Journal of Empirical Finance, Elsevier, vol. 1(1), pages 33-55, June.
    32. Michael J. Best & Robert R. Grauer, 1991. "Sensitivity Analysis for Mean-Variance Portfolio Problems," Management Science, INFORMS, vol. 37(8), pages 980-989, August.
    33. Chan, Louis K C & Karceski, Jason & Lakonishok, Josef, 1999. "On Portfolio Optimization: Forecasting Covariances and Choosing the Risk Model," Review of Financial Studies, Society for Financial Studies, vol. 12(5), pages 937-974.
    34. Shumway, Tyler, 1997. " The Delisting Bias in CRSP Data," Journal of Finance, American Finance Association, vol. 52(1), pages 327-340, March.
    35. Fleming, Jeff & Kirby, Chris & Ostdiek, Barbara, 2003. "The economic value of volatility timing using "realized" volatility," Journal of Financial Economics, Elsevier, vol. 67(3), pages 473-509, March.
    36. Dimson, Elroy & Marsh, Paul, 2001. "U.K. Financial Market Returns, 1955-2000," The Journal of Business, University of Chicago Press, vol. 74(1), pages 1-31, January.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. repec:spr:annopr:v:266:y:2018:i:1:d:10.1007_s10479-017-2619-8 is not listed on IDEAS
    2. Humphrey, Jacquelyn E. & Benson, Karen L. & Low, Rand K.Y. & Lee, Wei-Lun, 2015. "Is diversification always optimal?," Pacific-Basin Finance Journal, Elsevier, vol. 35(PB), pages 521-532.
    3. Auer, Benjamin R. & Schuhmacher, Frank, 2013. "Performance hypothesis testing with the Sharpe ratio: The case of hedge funds," Finance Research Letters, Elsevier, vol. 10(4), pages 196-208.

    More about this item

    Keywords

    Estimation risk; Mean–variance timing; Combined portfolio strategies;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:finana:v:20:y:2011:i:5:p:375-385. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Dana Niculescu). General contact details of provider: http://www.elsevier.com/locate/inca/620166 .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.