Portfolio management with tail dependence

ABSTRACT

Many publications, that treated with Portfolio Management, were devastating for all asset allocation models in the context of portfolios. The elimination of extreme events (asymmetric or tail dependence) during the portfolio construction process can reduce the skills of asset managers to reduce risk through diversification. The copula theory allows us to calculate an alternative to measure the dependence of extreme events in assets through the index lower tail dependence. We check that the strategies with tail dependence overcame Talmud rule, the Markowitz model and the model of Tu and Zhou by simulating 1,000 portfolios with 3, 5, 10 and 20 randomly selected assets from DJIA for the period 03/1990 until 12/2016. We conclude that models of tail dependence and Markowitz had more performance ex-ante than Talmud and the Tu and Zhou model for portfolios with 3, 5, 10 and 20 assets. Tail dependence models overcome Markowitz, in terms of cumulative return, in over 60% of months considered in the analysis. The results indicate that the Talmud rule should be discarded in a context of constructing portfolios with individual stocks ahead strategies with tail dependence.

KEYWORDS:

• Copula
• asset allocation
• tail dependence

JEL CLASSIFICATION:

• B23
• G12
• G11

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ The MVM assumes that asset returns follow a normal probability distribution.