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Portfolio selection: from under-diversification to concentration

Author

Listed:
  • Jiawen Xu

    (Shanghai University of Finance and Economics)

  • Yixuan Li

    (University of Waterloo
    University of Waterloo)

  • Kai Liu

    (University of Waterloo
    University of Prince Edward Island)

  • Tao Chen

    (University of Waterloo
    University of Waterloo
    Harvard University)

Abstract

The two opposing investment strategies, diversification and concentration, have often been directly compared. While there is much less dispute regarding Markowitz’s approach as the benchmark for diversification, the precise meaning of concentration in portfolio selection remains unclear. This paper offers a novel definition of concentration, along with an extreme value theory-based estimator for its implementation. When overlaying the performances derived from diversification (in Markowitz’s sense) and concentration (in our definition), we find an implied risk threshold, at which the two polar investment strategies reconcile—diversification has a higher expected return in situations where risk is below the threshold, while concentration becomes the preferred strategy when the risk exceeds the threshold. Different from the conventional concave shape, the estimated frontier resembles the shape of a seagull, which is piecewise concave. Further, taking the equity premium puzzle as an example, we demonstrate how the family of frontiers nested inbetween the estimated curves can provide new perspectives for research involving market portfolios.

Suggested Citation

  • Jiawen Xu & Yixuan Li & Kai Liu & Tao Chen, 2023. "Portfolio selection: from under-diversification to concentration," Empirical Economics, Springer, vol. 64(4), pages 1539-1557, April.
    • Handle: RePEc:spr:empeco:v:64:y:2023:i:4:d:10.1007_s00181-022-02300-x
    DOI: 10.1007/s00181-022-02300-x
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    More about this item

    Keywords

    Diversification and concentration; Efficient frontier; Market portfolio; Extreme value theory; Dimensional reduction;
    All these keywords.

    JEL classification:

    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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