Optimal Versus Naive Diversification: How Inefficient is the 1/N Portfolio Strategy?

Posted: 13 Apr 2009

See all articles by Victor DeMiguel

Victor DeMiguel

London Business School

Lorenzo Garlappi

University of British Columbia (UBC) - Sauder School of Business

Raman Uppal

EDHEC Business School; Centre for Economic Policy Research (CEPR)

Date Written: May 2009

Abstract

We evaluate the out-of-sample performance of the sample-based mean-variance model, and its extensions designed to reduce estimation error, relative to the naive 1/N portfolio. Of the 14 models we evaluate across seven empirical datasets, none is consistently better than the 1/N rule in terms of Sharpe ratio, certainty-equivalent return, or turnover, which indicates that, out of sample, the gain from optimal diversification is more than offset by estimation error. Based on parameters calibrated to the US equity market, our analytical results and simulations show that the estimation window needed for the sample-based mean-variance strategy and its extensions to outperform the 1/N benchmark is around 3000 months for a portfolio with 25 assets and about 6000 months for a portfolio with 50 assets. This suggests that there are still many “miles to go” before the gains promised by optimal portfolio choice can actually be realized out of sample.

Keywords: G11

Suggested Citation

DeMiguel, Victor and Garlappi, Lorenzo and Uppal, Raman, Optimal Versus Naive Diversification: How Inefficient is the 1/N Portfolio Strategy? (May 2009). The Review of Financial Studies, Vol. 22, Issue 5, pp. 1915-1953, 2009. Available at SSRN: https://ssrn.com/abstract=1376199 or http://dx.doi.org/hhm075

Victor DeMiguel (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Lorenzo Garlappi

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada

Raman Uppal

EDHEC Business School ( email )

58 rue du Port
Lille, 59046
France

Centre for Economic Policy Research (CEPR)

90-98 Goswell Road
London, EC1V 7RR
United Kingdom

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