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Markowitz meets Talmud: A combination of sophisticated and naive diversification strategies

  • Tu, Jun
  • Zhou, Guofu

The modern portfolio theory pioneered by Markowitz (1952) is widely used in practice and extensively taught to MBAs. However, the estimated Markowitz portfolio rule and most of its extensions not only underperform the naive 1/N rule (that invests equally across N assets) in simulations, but also lose money on a risk-adjusted basis in many real data sets. In this paper, we propose an optimal combination of the naive 1/N rule with one of the four sophisticated strategies--the Markowitz rule, the Jorion (1986) rule, the MacKinlay and Pástor (2000) rule, and the Kan and Zhou (2007) rule--as a way to improve performance. We find that the combined rules not only have a significant impact in improving the sophisticated strategies, but also outperform the 1/N rule in most scenarios. Since the combinations are theory-based, our study may be interpreted as reaffirming the usefulness of the Markowitz theory in practice.

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Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 99 (2011)
Issue (Month): 1 (January)
Pages: 204-215

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Handle: RePEc:eee:jfinec:v:99:y:2011:i:1:p:204-215
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505576

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  1. Lubos Pástor, 2000. "Portfolio Selection and Asset Pricing Models," Journal of Finance, American Finance Association, vol. 55(1), pages 179-223, 02.
  2. Stambaugh, Robert F., 1997. "Analyzing investments whose histories differ in length," Journal of Financial Economics, Elsevier, vol. 45(3), pages 285-331, September.
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  10. Michaud, Richard O. & Michaud, Robert O., 2008. "Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation," OUP Catalogue, Oxford University Press, edition 2, number 9780195331912, March.
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  12. Michael W. Brandt & Pedro Santa-Clara & Rossen Valkanov, 2009. "Parametric Portfolio Policies: Exploiting Characteristics in the Cross-Section of Equity Returns," Review of Financial Studies, Society for Financial Studies, vol. 22(9), pages 3411-3447, September.
  13. Klein, Roger W. & Bawa, Vijay S., 1976. "The effect of estimation risk on optimal portfolio choice," Journal of Financial Economics, Elsevier, vol. 3(3), pages 215-231, June.
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  16. 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.
  17. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
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