A Simple Diversified Portfolio Strategy

Abstract

We present a simple portfolio construction approach which is a blend of market weights and equal stock and sector weights. Our approach results in a highly diversified portfolio both on a stock level and on a sector level and generates higher portfolio returns at slightly lower risk than a market weighted index. We demonstrate that the higher returns of our diversified portfolio originate both from mitigating the link with market weights and from its higher return benefit due to diversification which we are able to capture because we rebalance our portfolio on a regular basis.

Our diversified portfolio exhibits only slightly higher turnover than a market weighted index and is less concentrated in mega-cap stocks. Instead it assigns somewhat higher weight to smaller stocks and sectors than a market weighted index. At the same time the diversified portfolio retains the characteristics of a broad market index and is therefore highly implementable and has very high investment capacity.

Our simple diversification strategy appears to be a superior way of capturing the equity risk premium compared to a market weighted portfolio. It therefore establishes a tougher benchmark for active fund managers than market weighted indexing as it results in well-diversified, high-capacity and low turnover portfolios that can be delivered very cheaply.

Keywords: diversification, diversification premium, equity

JEL Classification: G10