How Can we Diversify Portfolios?

Abstract

This thesis aims to provide new insights into how investors can diversify their portfolios by studying the benefits of different types of diversified portfolios, comparing the performance of various diversification strategies, and estimating the effect of U.S. monetary policy on portfolio diversification. The basic concept of portfolio diversification was proposed by American economist Harry Markowitz in his paper “Portfolio Selection” in 1952, which also laid the foundation for Modern Portfolio Theory. Thus, most investors understand the importance of diversification. However, due to the market’s volatility and unpredictability, asset selection and allocation in portfolios have proven to be a challenging task. As a result, researchers and investors have consistently focused their research on this topic.

This thesis contains three complete empirical studies, presented in Chapters two, three, and four, respectively, each with different objectives. Chapter two explores how U.S. investors can benefit from various types of portfolio options, including a stock (60%)-bond (40%) portfolio, an internationally diversified portfolio, an asset-diversified portfolio, or only investing in U.S. stocks. In this chapter, we discover that since 2009, U.S. investors are less likely to benefit from an internationally diversified portfolio due to the strong performance of the S&P 500 index. Chapter three compares the performance of various portfolio diversification strategies, including the naive diversified strategy (1/N rule), market capitalisation-weighted strategy, risk parity (equally weighted risk contribution) strategy, mean-variance (MV) strategy, Black-Litterman (BL) strategy, and three types of the Parametric Portfolio Policy (PPP) diversified strategies. Out of these, the naive diversified strategy (1/N rule), the market capitalisation-weighted strategy, and the risk parity (equally weighted risk contribution) strategy are three benchmarks, while the mean-variance (MV) strategy, the Black-Litterman (BL) strategy, and three types of the Parametric Portfolio Policy (PPP) diversified strategy are portfolio optimisation strategies. The mean-variance (MV) and Black-Litterman (BL) strategies consistently do better than the three benchmarks in terms of Sharpe ratio. The market capitalisation-weighted portfolio does better than the 1/N rule and risk parity portfolios among the three benchmarks. Chapter four investigates the impact of changes in the U.S. monetary policy on portfolio diversification. In this chapter, our results show that an unexpected Fed funds target rate cut (negative surprise) triggers an increase in the return of portfolios.