Un-Diversifying During Crises: Is It a Good Idea?

36 Pages Posted: 1 Aug 2016 Last revised: 22 Nov 2016

See all articles by Margherita Giuzio

Margherita Giuzio

European Central Bank (ECB)

Sandra Paterlini

University of Trento - Department of Economics and Management

Date Written: November 20, 2016


High levels of correlation among financial assets as well as extreme losses are typical during crises periods. In such situations, quantitative asset allocation models are often not robust to deal with estimation errors and lead to identify underperforming investment strategies. It is an open question if in such periods, it would be better to hold diversified portfolios, such as the equally weighted, rather than investing in few selected assets. In this paper, we show that alternative strategies developed by constraining the level of diversification of the portfolio, by means of a regularization constraint on the sparse lq-norm of portfolio weights, can better deal with the trade-off between risk diversification and estimation error. In fact, the proposed approach automatically selects portfolios with a small number of active weights and low risk exposure. Insights on the diversification relationships between the classical minimum variance portfolio, risk budgeting strategies and diversification-constrained portfolios are also provided. Finally, we show empirically that the diversification constrained-based lq-strategy outperforms state-of-art methods during crisis, with remarkable out-of-sample performance in risk minimization.

Keywords: Minimum Variance portfolio, Sparsity, Diversification, Regularization Methods

JEL Classification: G11, C58

Suggested Citation

Giuzio, Margherita and Paterlini, Sandra, Un-Diversifying During Crises: Is It a Good Idea? (November 20, 2016). Available at SSRN: https://ssrn.com/abstract=2815996 or http://dx.doi.org/10.2139/ssrn.2815996

Margherita Giuzio (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314

Sandra Paterlini

University of Trento - Department of Economics and Management ( email )

Via Inama 5
Trento, I-38100

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