It’s All in the Timing: Simple Active Portfolio Strategies that Outperform Naive Diversification

Abstract

DeMiguel et al. (2009) report that naive diversification dominates mean-variance optimization in out-of-sample asset allocation tests. Our analysis suggests that this is largely due to their research design, which focuses on mean-variance efficient portfolios that are subject to high estimation risk and extreme turnover. We find that mean-variance optimization outperforms naive diversification under many circumstances, but its advantage can easily be eroded by transactions costs. This motivates us to propose two types of mean-variance timing strategies, both characterized by low turnover. These strategies outperform naive diversification even in the presence of relatively high transactions costs. In contrast to DeMiguel et al. (2009), therefore, we conclude that using sample information to guide portfolio selection yields substantial benefits.