Optimal Versus Naive Diversification: How Inefficient is the 1/ N Portfolio Strategy?
Abstract
We evaluate the out-of-sample performance of the sample-based mean-variance model, and its extensions designed to reduce estimation error, relative to the naive 1-N portfolio. Of the 14 models we evaluate across seven empirical datasets, none is consistently better than the 1-N rule in terms of Sharpe ratio, certainty-equivalent return, or turnover, which indicates that, out of sample, the gain from optimal diversification is more than offset by estimation error. Based on parameters calibrated to the US equity market, our analytical results and simulations show that the estimation window needed for the sample-based mean-variance strategy and its extensions to outperform the 1-N benchmark is around 3000 months for a portfolio with 25 assets and about 6000 months for a portfolio with 50 assets. This suggests that there are still many "miles to go" before the gains promised by optimal portfolio choice can actually be realized out of sample. The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.
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The equal-weight buy-and-hold strategy is a widely accepted benchmark in portfolio research and provides a robust lower bound for comparing active strategies.
“This naive allocation is a widely accepted benchmark in portfolio research, reflecting passive index tracking behavior and providing a robust lower bound against which more sophisticated active strategies can be compared (DeMiguel et al., 2009; Duchin and Levy, 2009).”
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“This naive allocation is a widely accepted benchmark in portfolio research, reflecting passive index tracking behavior and providing a robust lower bound against which more sophisticated active strategies can be compared (DeMiguel et al., 2009; Duchin and Levy, 2009).”
- Authors
- DeMiguel, V., Garlappi, L., & Uppal, R.
- Affiliations
- London Business School (GB)
- The University of Texas at Austin (US)
- Centre for Economic Policy Research (GB)
- Corresponding author
- DeMiguel, Victor
- Venue
- Review of Financial Studies
- Publisher
- Oxford University Press (OUP)
- Published
- 2007-12-03
- Volume
- 22
- Issue
- 5
- Pages
- 1915-1953
- ISSN
- 0893-9454 (ISSN-L)
- 1465-7368
- OpenAlex
- W2163969674
- Cited by
- 3,199
- References
- 3
- Citations by year
- 2026: 271 · 2025: 277 · 2024: 208 · 2023: 180 · 2022: 202 · 2021: 245 · 2020: 191 · 2019: 201 · 2018: 232 · 2017: 190 · 2016: 185 · 2015: 151 · 2014: 150 · 2013: 144 · 2012: 142
- FWCI
- 59.78
- Type
- journal article
- Language
- en
- Open access
- closed
- Locations
- Review of Financial Studies (publishedVersion)
- RePEc: Research Papers in Economics (submittedVersion)
- Topics
- Social Sciences › Decision Sciences › Management Science and Operations Research › Risk and Portfolio Optimization
- Social Sciences › Economics, Econometrics and Finance › Finance › Financial Markets and Investment Strategies
- Social Sciences › Economics, Econometrics and Finance › Finance › Financial Risk and Volatility Modeling
- Keywords
- 1/N portfolio, naive diversification, portfolio optimization, mean-variance model, estimation error, out-of-sample performance, Sharpe ratio, portfolio turnover, US equity market
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