IDEAS home Printed from https://ideas.repec.org/a/pal/assmgt/v17y2016i4d10.1057_jam.2016.10.html
   My bibliography  Save this article

On entropy and portfolio diversification

Author

Listed:
  • Gianni Pola

    (ANIMA SGR)

Abstract

Entropy, a term used in Physics to quantify the degree of randomness in a complex system, is shown to be relevant for portfolio diversification. The link between entropy and diversification lies in the notion of uncertainty. We introduce the concept of available diversification in an investment universe and of diversification curves. We build a framework for assembling a fully diversified risk parity-like portfolio with a fundamental-based high-conviction strategy, through a constrained entropy-maximisation process by which a portion of potential portfolio return is swapped for extra diversification. The main results of this study are:• mean-variance optimised portfolios are highly concentrated and scarcely related to the asset return assumptions;• few basis points of expected returns can be converted into a huge amount of extra diversification that making the portfolio allocation more robust to parameter uncertainty;• on a more conceptual ground, we investigate the relationship between portfolio risk and diversification concluding that they should be managed distinctly.The empirical analysis presented in this work shows that entropy is a useful means to alleviate the lack of diversification of portfolios on the efficient frontier.

Suggested Citation

  • Gianni Pola, 2016. "On entropy and portfolio diversification," Journal of Asset Management, Palgrave Macmillan, vol. 17(4), pages 218-228, July.
    • Handle: RePEc:pal:assmgt:v:17:y:2016:i:4:d:10.1057_jam.2016.10
    DOI: 10.1057/jam.2016.10
    as

    Download full text from publisher

    File URL: http://link.springer.com/10.1057/jam.2016.10
    File Function: Abstract
    Download Restriction: Access to the full text of the articles in this series is restricted.
    File URL: https://libkey.io/10.1057/jam.2016.10?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Best, Michael J & Grauer, Robert R, 1991. "On the Sensitivity of Mean-Variance-Efficient Portfolios to Changes in Asset Means: Some Analytical and Computational Results," The Review of Financial Studies, Society for Financial Studies, vol. 4(2), pages 315-342.
    2. Roncalli, Thierry, 2013. "Introduction to Risk Parity and Budgeting," MPRA Paper 47679, University Library of Munich, Germany.
    3. repec:dau:papers:123456789/4688 is not listed on IDEAS
    4. Anil Bera & Sung Park, 2008. "Optimal Portfolio Diversification Using the Maximum Entropy Principle," Econometric Reviews, Taylor & Francis Journals, vol. 27(4-6), pages 484-512.
    5. repec:ebl:ecbull:v:7:y:2004:i:3:p:1-10 is not listed on IDEAS
    6. M. Hossein Partovi & Michael Caputo, 2004. "Principal Portfolios: Recasting the Efficient Frontier," Economics Bulletin, AccessEcon, vol. 7(3), pages 1-10.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Pier Francesco Procacci & Tomaso Aste, 2022. "Portfolio optimization with sparse multivariate modeling," Journal of Asset Management, Palgrave Macmillan, vol. 23(6), pages 445-465, October.
    2. Lauren Stagnol, 2016. "The Risk Parity Principle applied on a Corporate Bond Index using Duration Times Spread," EconomiX Working Papers 2016-27, University of Paris Nanterre, EconomiX.
    3. Będowska-Sójka, Barbara & Kliber, Agata, 2021. "Information content of liquidity and volatility measures," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 563(C).
    4. Ponta, Linda & Carbone, Anna, 2018. "Information measure for financial time series: Quantifying short-term market heterogeneity," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 510(C), pages 132-144.
    5. Nicola Giuseppe Castellano & Roy Cerqueti & Bruno Maria Franceschetti, 2021. "Evaluating risks-based communities of Mafia companies: a complex networks perspective," Review of Quantitative Finance and Accounting, Springer, vol. 57(4), pages 1463-1486, November.
    6. Marielle Jong, 2018. "Portfolio optimisation in an uncertain world," Journal of Asset Management, Palgrave Macmillan, vol. 19(4), pages 216-221, July.
    7. Buccioli, Alice & Kokholm, Thomas & Nicolosi, Marco, 2019. "Expected shortfall and portfolio management in contagious markets," Journal of Banking & Finance, Elsevier, vol. 102(C), pages 100-115.
    8. Francesco Cesarone & Rosella Giacometti & Manuel Luis Martino & Fabio Tardella, 2023. "A return-diversification approach to portfolio selection," Papers 2312.09707, arXiv.org.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Anis, Hassan T. & Kwon, Roy H., 2022. "Cardinality-constrained risk parity portfolios," European Journal of Operational Research, Elsevier, vol. 302(1), pages 392-402.
    2. Raphael Benichou & Yves Lemp'eri`ere & Emmanuel S'eri'e & Julien Kockelkoren & Philip Seager & Jean-Philippe Bouchaud & Marc Potters, 2016. "Agnostic Risk Parity: Taming Known and Unknown-Unknowns," Papers 1610.08818, arXiv.org.
    3. Frahm, Gabriel & Wiechers, Christof, 2011. "On the diversification of portfolios of risky assets," Discussion Papers in Econometrics and Statistics 2/11, University of Cologne, Institute of Econometrics and Statistics.
    4. Francesco Cesarone & Andrea Scozzari & Fabio Tardella, 2020. "An optimization–diversification approach to portfolio selection," Journal of Global Optimization, Springer, vol. 76(2), pages 245-265, February.
    5. Akhter Mohiuddin Rather & V. N. Sastry & Arun Agarwal, 2017. "Stock market prediction and Portfolio selection models: a survey," OPSEARCH, Springer;Operational Research Society of India, vol. 54(3), pages 558-579, September.
    6. Adil Rengim Cetingoz & Olivier Gu'eant, 2023. "Asset and Factor Risk Budgeting: A Balanced Approach," Papers 2312.11132, arXiv.org, revised May 2024.
    7. Philipp J. Kremer & Andreea Talmaciu & Sandra Paterlini, 2018. "Risk minimization in multi-factor portfolios: What is the best strategy?," Annals of Operations Research, Springer, vol. 266(1), pages 255-291, July.
    8. Adil Rengim Cetingoz & Jean-David Fermanian & Olivier Gu'eant, 2022. "Risk Budgeting Portfolios: Existence and Computation," Papers 2211.07212, arXiv.org, revised Sep 2023.
    9. Thorsten Poddig & Albina Unger, 2012. "On the robustness of risk-based asset allocations," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 26(3), pages 369-401, September.
    10. Marielle Jong, 2018. "Portfolio optimisation in an uncertain world," Journal of Asset Management, Palgrave Macmillan, vol. 19(4), pages 216-221, July.
    11. Sarah Perrin & Thierry Roncalli, 2019. "Machine Learning Optimization Algorithms & Portfolio Allocation," Papers 1909.10233, arXiv.org.
    12. Cesarone, Francesco & Mango, Fabiomassimo & Mottura, Carlo Domenico & Ricci, Jacopo Maria & Tardella, Fabio, 2020. "On the stability of portfolio selection models," Journal of Empirical Finance, Elsevier, vol. 59(C), pages 210-234.
    13. Davide Benedetti & Enrico Biffis & Fotis Chatzimichalakis & Luciano Lilloy Fedele & Ian Simm, 2021. "Climate change investment risk: optimal portfolio construction ahead of the transition to a lower-carbon economy," Annals of Operations Research, Springer, vol. 299(1), pages 847-871, April.
    14. Vasyl Golosnoy & Benno Hildebrandt & Steffen Köhler, 2019. "Modeling and Forecasting Realized Portfolio Diversification Benefits," JRFM, MDPI, vol. 12(3), pages 1-16, July.
    15. Amritansu Ray & Sanat Kumar Majumder, 2018. "Multi objective mean–variance–skewness model with Burg’s entropy and fuzzy return for portfolio optimization," OPSEARCH, Springer;Operational Research Society of India, vol. 55(1), pages 107-133, March.
    16. Gilles Boevi Koumou, 2020. "Diversification and portfolio theory: a review," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 34(3), pages 267-312, September.
    17. Sahamkhadam, Maziar & Stephan, Andreas & Östermark, Ralf, 2022. "Copula-based Black–Litterman portfolio optimization," European Journal of Operational Research, Elsevier, vol. 297(3), pages 1055-1070.
    18. Charles-Albert Lehalle & Guillaume Simon, 2021. "Portfolio selection with active strategies: how long only constraints shape convictions," Journal of Asset Management, Palgrave Macmillan, vol. 22(6), pages 443-463, October.
    19. Muhinyuza, Stanislas & Bodnar, Taras & Lindholm, Mathias, 2020. "A test on the location of the tangency portfolio on the set of feasible portfolios," Applied Mathematics and Computation, Elsevier, vol. 386(C).
    20. Candelon, B. & Hurlin, C. & Tokpavi, S., 2012. "Sampling error and double shrinkage estimation of minimum variance portfolios," Journal of Empirical Finance, Elsevier, vol. 19(4), pages 511-527.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:pal:assmgt:v:17:y:2016:i:4:d:10.1057_jam.2016.10. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Sonal Shukla or Springer Nature Abstracting and Indexing (email available below). General contact details of provider: http://www.palgrave-journals.com/ .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.