Diversification benefits and strategic portfolio allocation across asset classes: the case of the US markets

Mohamed El Hedi Arouri (), Duc Khuong Nguyen () and Kuntara Pukthuanthong ()
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Mohamed El Hedi Arouri: University of Auvergne and EDHEC Business School, France
Duc Khuong Nguyen: IPAG Lab, IPAG Business School, France
Kuntara Pukthuanthong: Department of Finance, San Diego State University, United States

No 177, Working Papers from Development and Policies Research Center (DEPOCEN), Vietnam

Abstract: We investigate the diversification benefits and optimal portfolio allocation across different US asset classes. Our results from applying the principal component analysis (PCA) show that although there is an increasing trend in market integration, five major financial markets (equities, bonds, currencies, commodities, and real estate) appear to be weakly and at most moderately integrated. Applying the mean-variance portfolio simulations and out-of-sample analysis to evaluate the benefits of diversification, we find that adding new asset classes such as oil, precious metals, currency, and real estate into a traditional portfolio of stocks and bonds significantly improves its risk-adjusted performance. Diversification benefit is low during contagion periods defined as a period when correlation of residuals from PC regression is significantly different from zero. Nonetheless, an additional gain from diversification is greater during contagion periods than normal periods. Bonds provide the best hedge during contagion periods whereas stocks perform the best during normal periods.

Keywords: US asset classes; portfolio allocation; market integration; contagion; principal component analysis (search for similar items in EconPapers)
JEL-codes: G11 G12 (search for similar items in EconPapers)
Pages: 59 pages
Date: 2014
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