When to Put All Your Eggs in One Basket... When Diversification Increases Portfolio Risk!

Abstract:     
Portfolio diversification may not always lower the portfolio risk, but may actually increase it. It depends on the distributional stability characteristics and long memory of the underlying rates of return. This disturbing result is based on the theoretical Fama-Samuelson proposition of 1965-67, which extends the portfolio mean-variance diversification results of Markowitz from Gaussian to non-Gaussian stable distributions. This extension is at the cost of introducing third (skewness) and fourth (kurtosis) moments in the diversification space. There exists now ample empirical evidence for it, since most financial return series are non-Gaussian and stable and have long memory, e.g., the S&P500 Index return series.

Number of Pages in PDF File: 7

Keywords: Portfolio management, distibutional stability, long memory, financial risk

JEL Classification: G12, G13, G14, C23

working papers series