Small Caps in International Equity Portfolios: The Effects of Variance Risk

Massimo Guidolin and Giovanna Nicodano

No 41, CeRP Working Papers from Center for Research on Pensions and Welfare Policies, Turin (Italy)

Abstract: Small capitalization stocks are known to have asymmetric risk across bull and bear markets. This paper investigates how variance risk affects international equity diversification by examining the portfolio choice of a power utility investor confronted with an asset menu that includes (but is not limited to) European and North American small equity portfolios. Stock returns are generated by a multivariate regime switching process that is able to account for both non-normality and predictability of stock returns. Non-normality matters for portfolio choice because the investor has a power utility function, implying a preference for positively skewed returns and aversion to kurtosis. We find that small cap portfolios command large optimal weights only when regime switching (and hence variance risk) is ignored. Otherwise a rational investor ought to hold a well-diversified portfolio. However, the availability of small caps substantially increases expected utility, in the order of riskless annualized gains of 3 percent and higher. These findings are robust to a number of modifications concerning the coefficient of relative risk aversion, the investment horizon, short-sale possibilities, and the exact structure of the asset menu.

Keywords: strategic asset allocation; markov-switching; size effects; liquidity (variance) risk (search for similar items in EconPapers)
Pages: 58 pages
Date: 2005-02
New Economics Papers: this item is included in nep-cfn, nep-fin, nep-fmk, nep-rmg and nep-upt
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Citations: View citations in EconPapers (4)

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http://www.cerp.carloalberto.org/wp-content/uploads/2008/12/wp_41_ita.pdf?f6fa34 First version, 2005 (application/pdf)

Related works:
Journal Article: Small caps in international equity portfolios: the effects of variance risk (2009)
Working Paper: Small caps in international equity portfolios: the effects of variance risk (2007)
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Persistent link: https://EconPapers.repec.org/RePEc:crp:wpaper:41

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