Markowitz’s Mean–Variance Rule and the Talmudic Diversification Recommendation
Markowitz’s breakthrough Mean–Variance theoretical article is the foundation of the CAPM and many other models in economics and finance. But the Mean–Variance rule is also widespread in practice, and this is the focus of this paper. While expected utility theory and Markowitz’s classical diversification theory assert that the optimal diversification depends on the joint distribution of returns, experiments reveal that subjects tend to ignore the joint distribution and adopt the naïve investment strategy called the “1 ∕ N rule,” which assigns an equal weight to each security the subjects face. We test the efficiency of the “1 ∕ N rule” and find that in in-sample, its employment induces a substantial expected utility loss. However, the out-of-sample case, which is the relevant framework for investors, reveals a relatively small loss and in many cases a gain. The advantage of the “1 ∕ N rule” in the out-of-sample analysis is that it is not exposed to estimation errors.
KeywordsRisk Aversion Versus Strategy Institutional Investor Investment Strategy Relative Risk Aversion
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