Maximizing positive porfolio diversification

Abstract

Abstract-In this article we introduce a new strategy for optimal diversification which combines elements of Diversified Risk Parity [1], [2] and Diversification Ratio [3], with emphasis on positive risk premiums. The Uncorrelated Positive Bets strategy involves the identification of reliable, independent sources of randomness and the quantification of their positive risk premium. We use principal component analysis to identify the most significant sources of randomness contributing to the market and then apply the Randomness Deficiency Coefficient metric [4] and principal portfolio positivity to identify a set of reliable uncorrelated positive bets. Portfolios are then optimized by maximizing their diversified positive risk premium. We contrast the performance of a range of diversification strategies for a portfolio held for a two-year out-of-sample period with a 30 stock constraint. In particular, we introduce the notion of diversification inefficiency to explain why diversification strategies might outperform the market.

Further evidence in support of a low-volatility anomaly: Optimizing buy-and-hold portfolios by minimizing historical aggregate volatility

“…Informational efficiency entails that current prices reflect all publicly available information, and that prices instantly change to reflect new public information. Accordingly, all stocks, and indeed all portfolios of stocks, should follow a random walk, where knowledge of past events has no value for predicting future prices changes (Maguire et al, 2014).…”

“…However, the notion of short-term individual stock efficiency described by the EMH is a separate concept to that of longterm market diversification efficiency. Even if a market is prediction-efficient it may not be diversification-efficient: Sophisticated diversifiers may be drawing down a larger proportion of the long-term risk premium the market provides, leaving other naive diversifiers to shoulder risk without the expected rewards (Maguire et al, 2014). The central tenet of CAPM, namely that return is linearly related to beta, assumes that the market represents the most diversified index.…”

“…The central tenet of CAPM, namely that return is linearly related to beta, assumes that the market represents the most diversified index. But if that's not true then investors who simply buy the market index may be transferring their risk premiums to sophisticated diversifiers who hold lower volatility portfolios (Maguire et al, 2014).…”

“…While there is much focus by investment companies on exploiting short-term pricing inefficiencies, there is less awareness of long-term algorithmic diversification strategies (e.g. Maguire et al, 2014;Choueifaty et al, 2013). While pricing inefficiency can be exploited to generate quick short-term profits, diversification inefficiency only delivers over the longer term, and requires greater tenacity to exploit.…”

“…It is worth noting that the portfolios involving greater number of stocks (e.g. [30) outperformed those with fewer stocks (e.g.\10), suggesting that a minimum-weighting constraint might reduce overfitting for those algorithms that tend to identify portfolios with fewer components (see Maguire et al, 2014). In sum, the results as a whole offer strong support for the idea that low-volatility portfolios can outperform the market even when following a simple buy-and-hold strategy.…”