The Attenuation of Idiosyncratic Risk Under Alternative Portfolio Weighting Strategies: Recent Evidence from the UK Equity Market
International Journal of Economics and Finance; Vol. 4, No. 11; 2012
14 Pages Posted: 16 Sep 2012 Last revised: 20 Sep 2012
Date Written: September 20, 2012
In this study, we investigate the attenuation of idiosyncratic risk and corresponding benefits of diversification for equally weighted and market capitalization weighted portfolios in the UK Equity Market over 2002 - 2012. We analyze the absolute benefits of risk reduction by testing the homogeneity of variances of portfolios of different sizes using Levene's Test. Next, we perform a cost-benefit analysis to determine the return benefit of diversification from a practical perspective. We find that the absolute benefits of diversification for an equally weighted portfolio are greater in the 'crisis' than 'pre-crisis' period, but when we analyze the results from a practical perspective the benefits fall dramatically and the results are reversed. When comparing the benefits of market capitalization weighted and equally weighted portfolios, we note that the benefits of diversification tend to be greater for an equally weighted portfolio for small portfolios but that a crossover occurs as the size of the portfolio increases. The relative benefits of diversification under these different weighting strategies are thus highly dependent upon the state of the market and further study is needed to determine why the diversification benefits for the alternative weighting strategies decay at varying rates.
Keywords: portfolio diversification, idiosyncratic risk, index funds, weighting methodology
JEL Classification: C15, G01, G11, G17
Suggested Citation: Suggested Citation