Combining Tail Risk Management and Modern Portfolio Theory

Does combining avoidance of fat tail losses with a traditional portfolio optimization strategy enhance performance? In her January 2011 paper entitled “The Economic Value of Controlling for Large Losses in Portfolio Selection”, Alexandra Dias investigates the effectiveness of combining tail loss risk management with minimum variance efficiency. This approach essentially seeks to add avoidance of Black Swans to the benefit of diversification. The investigation consists of testing four long-only strategies using 224 months of rolling historical returns on all possible combinations of three Dow Jones Industrial Average (DJIA) stocks by choosing each month: (1) the minimum variance portfolio with the smallest variance (benchmark strategy); (2) the minimum variance portfolio with the smallest probability of a large loss; (3) the minimum variance portfolio with the thinnest losses tail; and, (4) the minimum Value at Risk (VaR) portfolio with the smallest VaR. Strategies (2), (3) and (4) are alternatives for managing return distribution tail risk. Using monthly returns for the 24 DJIA stocks for which which prices are available during February 1973 through June 2010 (allowing 2,024 combinations of three stocks), she finds that: (more…)