It’s All in the Timing: Simple Active Portfolio Strategies that Outperform Naive Diversification
Posted: 4 Dec 2010
Date Written: November 18, 2010
DeMiguel et al. (2009) report that naive diversification dominates mean-variance optimization in out-of-sample asset allocation tests. Our analysis suggests that this is largely due to their research design, which focuses on portfolios that are subject to high estimation risk and extreme turnover. We find that mean-variance optimization often outperforms naive diversification, but turnover can erode its advantage in the presence of transactions costs. To address this issue, we develop two new methods of mean-variance portfolio selection – volatility timing and reward-to-risk timing – that deliver portfolios characterized by low turnover. These timing strategies outperform naive diversification even in the presence of high transactions costs.
Keywords: portfolio selection, mean-variance optimization, estimation risk, turnover, market timing, volatility timing
JEL Classification: G11, G12, C11
Suggested Citation: Suggested Citation