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Limitations of portfolio diversification through fat tails of the return distributions: some empirical evidence

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posted on 2023-06-09, 22:42 authored by Cheoljun Eom, Taisei Kaizoji, Giacomo Livan, Enrico Scalas
This study investigates the level of risk due to fat tails of the return distribution and the changes of tail fatness (TF) through portfolio diversification. TF is not eliminated through portfolio diversification, and, interestingly, the positive tail has declining fatness until a certain level is reached, while the negative tail has rising fatness. This indicates that fat tails are highly relevant to common factors on systematic risk and that the relevance of common factors is higher for the negative tail compared to the positive tail. In the portfolio diversification effect, the declining fatness of the positive tail further reduces risk, but the rising fatness of the negative tail does not contribute to this effect. The asymmetry between the fatness of the positive and negative tails in the return distribution corresponds to the asymmetry of the trade-off relationship between loss avoidance and profit sacrifice that is expected as a consequence of portfolio diversification. Investors use portfolio diversification to reduce their risk of suffering high losses, but following this strategy means sacrificing high-profit potential. Our study provides empirical confirmation for the practical limitation of portfolio diversification and explains why investors with diversified portfolios suffer high losses from market crashes. An examination of the Northeast Asian stock markets of China, Japan, Korea, and Taiwan show identical results.

History

Publication status

  • Published

File Version

  • Accepted version

Journal

North American Journal of Economics and Finance

ISSN

1062-9408

Publisher

Elsevier

Volume

56

Page range

1-17

Article number

a101358

Department affiliated with

  • Mathematics Publications

Research groups affiliated with

  • Probability and Statistics Research Group Publications

Full text available

  • Yes

Peer reviewed?

  • Yes

Legacy Posted Date

2021-01-11

First Open Access (FOA) Date

2022-01-06

First Compliant Deposit (FCD) Date

2021-01-11

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