The 1/N Investment Strategy from a Pedagogic Perspective: A Spreadsheet-Based Illustration

Abstract

The surprising empirical finding in the finance literature that the 1/N investment strategy outperforms portfolio optimization, followed by some intense debate on the topic, has given credence to this simple approach in the investment world . This paper, which draws on an Excel-based assignment in an introductory finance course, examines equally-weighted portfolios closely. The examination reveals the hidden role of the correlation of returns in such portfolios. In the context of equity investments, this paper presents a simple way to estimate portfolio risk for the purpose of examining how it varies as stocks are added to an equally-weighted portfolio. The simple appproach introduced here also allows the aggregate contribution of the individual covariances of stock returns to be established. Further, it allows an alternative measure of portfolio risk, the Gini coefficient, to be used as well.