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

Eom, Cheoljun, Kaizoji, Taisei, Livan, Giacomo and Scalas, Enrico (2021) Limitations of portfolio diversification through fat tails of the return distributions: some empirical evidence. North American Journal of Economics and Finance, 56. a101358 1-17. ISSN 1062-9408

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Abstract

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.

Item Type: Article
Keywords: Fat tails, Portfolio diversification, Common factors, Principal component analysis, Random matrix theory, Singular value decomposition
Schools and Departments: School of Mathematical and Physical Sciences > Mathematics
Research Centres and Groups: Probability and Statistics Research Group
SWORD Depositor: Mx Elements Account
Depositing User: Mx Elements Account
Date Deposited: 11 Jan 2021 09:35
Last Modified: 12 Jan 2021 11:00
URI: http://sro.sussex.ac.uk/id/eprint/96422

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