Optimal Versus Naive Diversification: How Inefficient is the ...

Optimal Versus Naive Diversification:How Inefficient is the 1/NPortfolio Strategy?Victor DeMiguelLondon Business SchoolLorenzo GarlappiUniversity of Texas at AustinRaman UppalLondon Business School and CEPRWe evaluate the out-of-sample performance of the sample-based mean-variance model, andits extensions designed to reduce estimation error, relative to the Naive 1/Nportfolio. Of the14 models we evaluate across seven empirical datasets, none is consistently better than the1/Nrule in terms of Sharpe ratio, certainty-equivalent return, or turnover, which indicatesthat, out of sample, the gain from Optimal diversification is more than offset by estimationerror. Based on parameters calibrated to the US equity market, our analytical results andsimulations show that the estimation window needed for the sample-based mean-variancestrategy and its extensions to outperform the 1/Nbenchmark is around 3000 months for aportfolio with 25 assets and about 6000 months for a portfolio with 50 assets.

3 Eight country indexes and 8+1 01/1970–07/2001 International the World Index Source: MSCI 4 SMB and HML portfolios and 2+1 07/1963–11/2004 MKT/SMB/HML the US equity market portfolio Source: Ken French’s Web site 5 Twenty size- and book-to-market portfolios and 20+1 07/1963–11/2004 FF-1-factor the US equity MKT Source: Ken French’s ...

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  Country, World, Index, Misc, World index

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