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Limitations of portfolio diversification through fat tails of the return distributions: some empirical evidence
journal contribution
posted on 2023-06-09, 22:42 authored by Cheoljun Eom, Taisei Kaizoji, Giacomo Livan, Enrico ScalasThis 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.
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Publication status
- Published
File Version
- Accepted version
Journal
North American Journal of Economics and FinanceISSN
1062-9408Publisher
ElsevierExternal DOI
Volume
56Page range
1-17Article number
a101358Department affiliated with
- Mathematics Publications
Research groups affiliated with
- Probability and Statistics Research Group Publications
Full text available
- Yes
Peer reviewed?
- Yes
Legacy Posted Date
2021-01-11First Open Access (FOA) Date
2022-01-06First Compliant Deposit (FCD) Date
2021-01-11Usage metrics
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