Building Diversified Portfolios that Outperform Out-of-Sample

31 Pages Posted: 17 Jul 2019

See all articles by Marcos Lopez de Prado

Marcos Lopez de Prado

Cornell University - Operations Research & Industrial Engineering; Abu Dhabi Investment Authority; True Positive Technologies

Date Written: May 23, 2016

Abstract

This paper introduces the Hierarchical Risk Parity (HRP) approach. HRP portfolios address three major concerns of quadratic optimizers in general and Markowitz’s CLA in particular: Instability, concentration and underperformance.

HRP applies modern mathematics (graph theory and machine learning techniques) to build a diversified portfolio based on the information contained in the covariance matrix. However, unlike quadratic optimizers, HRP does not require the invertibility of the covariance matrix. In fact, HRP can compute a portfolio on an ill-degenerated or even a singular covariance matrix, an impossible feat for quadratic optimizers. Monte Carlo experiments show that HRP delivers lower out-of-sample variance than CLA, even though minimum-variance is CLA’s optimization objective. HRP also produces less risky portfolios out-of-sample compared to traditional risk parity methods.

A presentation can be found at http://ssrn.com/abstract=2713516.

Keywords: Risk parity, tree graph, cluster, dendogram, linkage, metric space

JEL Classification: G0, G1, G2, G15, G24, E44

Suggested Citation

López de Prado, Marcos and López de Prado, Marcos, Building Diversified Portfolios that Outperform Out-of-Sample (May 23, 2016). Journal of Portfolio Management, 2016; https://doi.org/10.3905/jpm.2016.42.4.059. , Available at SSRN: https://ssrn.com/abstract=2708678 or http://dx.doi.org/10.2139/ssrn.2708678

Marcos López de Prado (Contact Author)

Cornell University - Operations Research & Industrial Engineering ( email )

237 Rhodes Hall
Ithaca, NY 14853
United States

HOME PAGE: http://www.orie.cornell.edu

Abu Dhabi Investment Authority ( email )

211 Corniche Road
Abu Dhabi, Abu Dhabi PO Box3600
United Arab Emirates

HOME PAGE: http://www.adia.ae

True Positive Technologies ( email )

NY
United States

HOME PAGE: http://www.truepositive.com

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