A comparison of four different diversification strategies in the Norwegian market with portfolios consisting of stocks and bonds : a comparison of risk and return in portfolios of stocks and bonds in the Norwegian market based on equal weighting, 60/40, mean-variance, and risk parity

Abstract

This thesis takes a closer look on the Norwegian bond and stock market in the period 1998- 2012 and compares different portfolio allocations. The problem statement is as follows: “A comparison of risk and return in portfolios of stocks and bonds in the Norwegian market based on equal weighting, 60/40, mean-variance, and risk parity” Applied relevant theory is the framework of modern portfolio theory and the mean-variance optimization as well as the Sharpe ratio and the risk parity approach. The portfolio construction and calculation of portfolio weights are obtained through the use of Excel and the Problem Solver. The results show that the naïve equal weighting portfolio and the 60/40 stock/bond portfolio outperforms both the mean-variance and the risk parity portfolio. The mean-variance portfolio realizes the highest Sharpe ratio in line with the objective of the methodology, followed by the risk parity portfolio. Both portfolios realizes Sharpe ratios superior to the equal weighting and 60/40 portfolios. The risk parity portfolio has some interesting characteristics such as equal return correlation to stocks and bonds making the portfolio truly diversified and not solely dependent on stock or bond returns, and it has equal risk contribution to the portfolios total risk from both stocks and bonds. In the absence of leverage, however, the expected return of the risk parity portfolio and the mean-variance portfolio is too low to be compelling for most investors. By applying leverage to the risk parity portfolio or the mean-variance portfolio up to the naïve equal weighting or traditional 60/40 portfolios risk-levels, an investor can theoretically achieve higher returns. This depends, however, on the cost of leverage.