When Will Mean-Variance Efficient Portfolios Be Well Diversified?

Authors

  • RICHARD C. GREEN,

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    • Green is from Carnegie Mellon University and Hollifield is from the University of British Columbia. We wish to thank seminar participants at Carnegie Mellon University, Rutgers University, Queens University, the University of Colorado at Boulder, the Stockholm School of Economics, and the 1990 Western Finance Association meetings for helpful comments on this work. The comments and guidance of the editor, René Stulz, and of two anonymous referees significantly improved the paper. Hollifield gratefully acknowledges the support of the Social Sciences and Humanities Research Council of Canada.

  • BURTON HOLLIFIELD

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    • Green is from Carnegie Mellon University and Hollifield is from the University of British Columbia. We wish to thank seminar participants at Carnegie Mellon University, Rutgers University, Queens University, the University of Colorado at Boulder, the Stockholm School of Economics, and the 1990 Western Finance Association meetings for helpful comments on this work. The comments and guidance of the editor, René Stulz, and of two anonymous referees significantly improved the paper. Hollifield gratefully acknowledges the support of the Social Sciences and Humanities Research Council of Canada.


ABSTRACT

We characterize the conditions under which efficient portfolios put small weights on individual assets. These conditions bound mean returns with measures of average absolute covariability between assets. The bounds clarify the relationship between linear asset pricing models and well-diversified efficient portfolios. We argue that the extreme weightings in sample efficient portfolios are due to the dominance of a single factor in equity returns. This makes it easy to diversify on subsets to reduce residual risk, while weighting the subsets to reduce factor risk simultaneously. The latter involves taking extreme positions. This behavior seems unlikely to be attributable to sampling error.

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