Journal of Investment Strategies

Risk.net

Optimal diversification

George Chacko, Robert McMillan and Karl Neumar

ABSTRACT

In this paper we develop a new approach to portfolio construction that relies solely on the covariance structure of the investment opportunity set. Using this new approach leads to an alternative to the mean-variance efficient set of portfolios as traditionally implemented. We define an "optimally diversified" portfolio as one which is equally correlated to each of its components. We show empirically in this paper that using this "optimally diversified" portfolio construction methodology results in a significant improvement in portfolio performance over traditional mean-variance efficient portfolios as well as naively diversified (eg, equally weighted) portfolios.

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