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The Opportunity Cost of Holding a “Naive” Portfolio

The paper explores the effect of “naive” portfolio strategies on investors’ welfare. A “naive” portfolio as a sub-optimal investment strategy produces sub-optimal asset allocations that result in investors’ welfare losses. To measure those losses I compare sub-optimal portfolios with optimal portfolios using the proportionate opportunity cost with various CRRA utility functions. A vector autoregression is used to generate the joint distribution of asset returns. I show that the opportunity cost of investing in “naive” portfolios does not exceed 16.7% while investing in the optimal number of asset and does not exceed 20.4% while investing in a sub-optimal number of assets.