AN EMPIRICAL STUDY OF TIME DIVERSIFICATION USING RISK-ADJUSTED PERFORMANCE MEASURES

Abstract

The concept of time diversification has long been debated among theoretical researchers and empiricists. While many theoretical models based on expected utility theory reject the effects of time diversification, the evidence from empirical studies on time diversification is mixed. This study seeks to test the validity of time diversification using highly intuitive performance measures that have foundations based on utility theory and that incorporate investors’ aversion to downside risks. To mitigate the problem of insufficient non-overlapping long horizon returns, we employ bootstrap simulations that account for time series dependencies in the data. Our results show that time diversification effects vary depending on which performance measures are used. In general, evidence using the standard Sharpe and the Generalized Sharpe ratios do not support time diversification. However, performance measures that incorporate downside risks such as the Sortino and Upside potential ratios provide strong support for time diversification as the optimal portfolios consistently have a higher allocation of equities as the investment horizons increase. The findings also indicate higher allocations to riskier assets when the investor has a higher desired target return. In addition, all four performance measures examined in this study indicate that apart from time diversification, there is still a need to diversify across different asset classes.