How Inefficient are Simple Asset-Allocation Strategies?

77 Pages Posted: 3 Mar 2005

See all articles by Lorenzo Garlappi

Lorenzo Garlappi

University of British Columbia (UBC) - Sauder School of Business

Victor DeMiguel

London Business School

Raman Uppal

EDHEC Business School; Centre for Economic Policy Research (CEPR)

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Date Written: February 2005

Abstract

In this paper, we wish to evaluate the performance of simple asset-allocation strategies such as allocating 1/N to each of the N assets available. To do this, we compare the out-of-sample performance of such simple allocation rules to about ten models of optimal asset-allocation (including both static and dynamic models) for ten data sets. We find that the simple assetallocation rule of 1/N is not very inefficient. In fact, it performs quite well out-of-sample: it typically has a higher Sharpe ratio, a higher certainty equivalent value, and a lower turnover than the policies from the optimal asset allocation. The intuition for the good performance of the 1/N policy is that the loss from naive rather than optimal diversification is smaller than the loss arising from having to optimize using moments that have been estimated with error. Simulations show that the performance of policies from optimizing models relative to the 1/N rule improves with the length of the estimation window (which reduces estimation error) and also with N (which increases the gains from optimal diversification). But, even with an estimation window of 50 years, the difference in the performance of the 1/N policy and the policies from models of optimal asset allocation is not statistically significant.

Keywords: Portfolio choice, asset allocation, investment management

JEL Classification: G11

Suggested Citation

Garlappi, Lorenzo and DeMiguel, Victor and Uppal, Raman, How Inefficient are Simple Asset-Allocation Strategies? (February 2005). Available at SSRN: https://ssrn.com/abstract=676997 or http://dx.doi.org/10.2139/ssrn.676997

Lorenzo Garlappi

University of British Columbia (UBC) - Sauder School of Business ( email )

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Victor DeMiguel (Contact Author)

London Business School ( email )

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Raman Uppal

EDHEC Business School ( email )

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France

Centre for Economic Policy Research (CEPR)

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