Asset classes and portfolio diversification: evidence from a stochastic spanning approach

Abstract We propose a stochastic spanning approach to assess whether a traditional portfolio of stocks and bonds spans augmented portfolios including commodities, foreign exchange, and real estate. We empirically show that in all seven portfolio combinations, the augmented portfolio is not spanned by the traditional one. Our results are further confirmed by both parametric and non-parametric tests in an out-of-sample setting. Traditional investors face opportunity cost of up to 0.77% per month by not switching to an augmented portfolio including alternative asset classes. Additional analysis demonstrates that diversification benefits are stronger for times of declining economy and financial markets.