Include forecasts in portfolio construction
The ‘gold standard’ of equally-weighted portfolio assets is not foolproof, Plato Investment Management believes.
The firm’s head of long/short strategies, Dr David Allen, said a 2009 London Business School study entitled Optimal Versus Naive Diversification: How Inefficient is the 1/N Portfolio Strategy claimed to demonstrate that simply equally weighting each asset in a portfolio would outperform mean-variance optimisation was false.
Plato said the mean-variance portfolio construction technique, which traded off the expected return and risk of all assets was first developed by Harry Markowitz in the 1950s and, up until the 2009 study, it was considered the ‘gold standard’ of modern finance and taught in MBA programs worldwide.
“Ten years later, our findings published in the Financial Analysts Journal have cast doubt on the London Business School study,” Allen said.
“We show that Markowitz’s mean-variance outperforms equal weighting handsomely and if investors can forecast, the gains from adopting mean-variance are very large indeed.
“The key take-away for investors is that it is essential to account for the relative, return, risk and correlation of assets when constructing portfolios. In these turbulent times, the benefits of lower risk through diversification are perhaps more important than ever.”
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