Markowitz Meets Talmud: A Combination of Sophisticated and Naive Diversification Strategies

• Main Authors: TU, Jun, ZHOU, Guofu
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2011
• Subjects: Portfolio choice; Mean-variance analysis; Parameter uncertainty; Finance and Financial Management; Portfolio and Security Analysis
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/1105; https://ink.library.smu.edu.sg/context/lkcsb_research/article/2104/viewcontent/TZ50.pdf
• Institution: Singapore Management University

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.