Undiversifying During Crises: Is It a Good Idea?

38 Pages Posted: 5 Dec 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: December 2, 2016

Abstract

High levels of correlation among financial assets, as well as extreme losses, are typical during crisis periods. In such situations, quantitative asset allocation models are often not robust enough to deal with estimation errors and lead to identifying 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 crises, 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, Undiversifying During Crises: Is It a Good Idea? (December 2, 2016). FRB of Cleveland Working Paper No. 16-28. Available at SSRN: https://ssrn.com/abstract=2879619

Margherita Giuzio (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Sandra Paterlini

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

Via Inama 5
Trento, I-38100
Italy

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