The 1/n Pension Investment Puzzle |
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Authors: | Heath Windcliff Phelim P Boyle |
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Institution: | 1. TD Securities;2. Centre for Advanced Studies in Finance, School of Accountancy , University of Waterloo, 200 University Ave , West, Waterloo , Ontario , Canada NZL 3G1 |
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Abstract: | Abstract This paper examines the so-called 1/n investment puzzle that has been observed in defined contribution plans whereby some participants divide their contributions equally among the available asset classes. It has been argued that this is a very naive strategy since it contradicts the fundamental tenets of modern portfolio theory. We use simple arguments to show that this behavior is perhaps less naive than it at first appears. It is well known that the optimal portfolio weights in a mean-variance setting are extremely sensitive to estimation errors, especially those in the expected returns. We show that when we account for estimation error, the 1/n rule has some advantages in terms of robustness; we demonstrate this with numerical experiments. This rule can provide a risk-averse investor with protection against very bad outcomes. |
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