Un-Diversifying During Crises: Is It a Good Idea?
36 Pages Posted: 1 Aug 2016 Last revised: 22 Nov 2016
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: Suggested Citation