The reasons why maximum diversification is better than minimum risk, including in terms of risk
Maria-Laura Torrente () and
Pierpaolo Uberti ()
Additional contact information
Maria-Laura Torrente: University of Genoa
Pierpaolo Uberti: University of Milano-Bicocca
Journal of Asset Management, 2025, vol. 26, issue 6, No 5, 642-675
Abstract:
Abstract In well-defined experimental settings, we evaluate the out-of-sample performance of two asset allocation paradigms: minimum risk and maximum diversification. Specifically, for each given risk measure, we compare the optimal minimum risk allocation with the allocation obtained by maximizing a portfolio diversification measure induced by the same risk measure. The experiment is performed in an out-of-sample, long-only framework, accounting for proportional transaction costs and different lengths of both the estimation window and the holding period. The strategies are compared in terms of numerical stability, return, the Sharpe ratio, and risk, as measured through the same risk measures used for calculating the optimal allocation: variance of returns, mean absolute deviation, value at risk, and expected shortfall at significance levels of 1% and 5%. We show that the maximum diversification strategies are highly competitive, if not generally superior, to the risk minimization allocations. This result supports well-known empirical findings of naive investment strategies that are difficult to beat in practice. Risk minimization strategies require highly accurate forecasts of future returns to perform well. Moreover, these strategies exhibit extreme numerical instability, where even infinitesimal variations in the inputs can dramatically alter the optimal allocation. Therefore, implementation costs are high, significantly impairing performance. In contrast, maximum diversification strategies are less sensitive to minor changes in the input parameters, providing stable allocations that are less affected by transaction costs. Furthermore, these strategies do not require accurate predictions of future returns and are effective in controlling investment risk.
Keywords: Minimum risk; Maximum diversification; Out-of-sample risk; Out-of-sample performance; C02; G11 (search for similar items in EconPapers)
Date: 2025
References: Add references at CitEc
Citations:
Downloads: (external link)
http://link.springer.com/10.1057/s41260-025-00420-4 Abstract (text/html)
Access to the full text of the articles in this series is restricted.
Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.
Export reference: BibTeX
RIS (EndNote, ProCite, RefMan)
HTML/Text
Persistent link: https://EconPapers.repec.org/RePEc:pal:assmgt:v:26:y:2025:i:6:d:10.1057_s41260-025-00420-4
Ordering information: This journal article can be ordered from
http://www.springer.com/finance/journal/41260
DOI: 10.1057/s41260-025-00420-4
Access Statistics for this article
Journal of Asset Management is currently edited by Marielle de Jong and Dan diBartolomeo
More articles in Journal of Asset Management from Palgrave Macmillan
Bibliographic data for series maintained by Sonal Shukla () and Springer Nature Abstracting and Indexing ().