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Testing the simplest asset allocation rule: 1/N

Testing the simplest asset allocation rule: 1/N

04-12-2014 | Research

An important decision investors have to make, is how to allocate their assets. They need to strike a balance between risk and expected return in order to realize their financial goals.

testing-the-simplest-asset-allocation-rule-260x100.jpgDiversification is not a new idea. The Talmud already suggests doing so by simply spreading your wealth equally over the different asset classes available. This simple asset allocation rule has been put on the defensive since the rise in popularity of the Modern Portfolio Theory (MPT) developed by Markowitz in 1952. This theory leans heavily on mathematical modelling using correlations between different assets.

However, recent studies* into asset allocation conclude that the simple allocation rule still works surprisingly well. It scores well on Sharpe ratio compared to other more complicated asset allocation strategies. These other strategies are based on passive allocation models, such as the MPT, and on dynamic strategies.

So what is behind the success of the simple asset-allocation rule? Risk and costs are managed quite effectively by avoiding extreme positions in one particular asset and keeping portfolio turnover low. On the contrary, the various more complicated strategies depend heavily on parameters which are notoriously difficult to predict: future returns, volatility of returns and correlations. These parameters can lead to extreme positions and may require frequent rebalancing.

Robeco Quantitative Research believes the simple 1/N allocation rule combined with periodic rebalancing is a good starting point. It can for instance be applied to a factor portfolio including value, momentum and low-volatility equities. We are currently investigating various alternative approaches to equally weighted factor allocation.

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