Diversification benefits and strategic portfolio allocation across asset classes: The case of the US markets

We investigate the diversification benefits and optimal portfolio allocation across different US asset classes. Our results from applying the principal component analysis (PCA) show that although there is an increasing trend in market integration, five major financial markets (equities, bonds, currencies, commodities, and real estate) appear to be weakly and at most moderately integrated. Applying the mean-variance portfolio simulations and out-of-sample analysis to evaluate the benefits of diversification, we find that adding new asset classes such as oil, precious metals, currency, and real estate into a traditional portfolio of stocks and bonds significantly improves its risk -adjusted performance. Diversification benefit is low during contagion periods defined as a period when correlation of residuals from PC regression is significantly different from zero. Nonetheless, an additional gain from diversification is greater during contagion periods than normal periods. Bon ds provide the best hedge during contagion periods whereas stocks perform the best during normal periods.