Un-diversifying during crises: Is it a good idea?
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High levels of correlation among financial assets and extreme losses are typical during crises. In such situations, investing in few assets might be a better choice than holding diversified portfolios. We show that constraining the sparse \(\ell _q\)-norm of portfolio weights automatically controls diversification and selects portfolios with a small number of active weights and low risk, in presence of high correlation and volatility. We highlight the diversification relationships between the minimum variance portfolio, risk budgeting strategies and diversification-constrained portfolios. Finally, we show empirically that the \(\ell _q\)-strategy can successfully cope with bear markets by shrinking portfolio weights and total amount of shorting.
KeywordsDiversification Regularization methods Minimum variance Sparsity
Mathematics Subject Classification91G10 91G70 91-08
We would like to thank the two anonymous referees and the Associate Editor for providing us with constructive and detailed comments that have improved the quality of our paper. Sandra Paterlini gratefully acknowledges financial support from ICT COST Action IC1408 “Computationally-intensive methods for the robust analysis of non-standard data”.
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