Beating The Market

Abstract

It is argued that with a small number of stocks (N) in a portfolio (which suits individuals rather than institutional investors), naive Talmudic diversification rule (1/N) offers a superior trading outcome against mathematically optimal portfolios due to its robustness against estimation error. As this puzzle has not been resolved, we explore it using an alternative portfolio choice problem that seeks to outperform the benchmark market index – FTSE Bursa Malaysia KLCI. This study makes a significant contribution by using an industry-common objective function and also incorporating floor/ceiling constraints and the effect of delisting. Using evolutionary algorithm, we construct optimal portfolios with varying Ns in-sample for out-of-sample analysis. We find that 1/N is superior with smaller Ns, although optimised portfolio dominates as N increases. However, with both diversification policies underperform the market and produce very low Sharpe ratios, their efficacies for practical applications are highly suspect