Adding Oil to a Traditional Portfolio: Diversification Potential and Performance Through a Portfolio Theory Approach

Abstract

Motivated by oil’s historical importance in the global economy and its evolving behavior amid financialization, this thesis examines how the inclusion of oil affects the diversification and portfolio performance of a traditional portfolio of stocks and bonds. To address this question, a correlation analysis is conducted between oil, traditional assets, and inflation. Furthermore, the Markowitz mean-variance framework is applied through the construction of Minimum-Variance, Tangency, Bayes-Stein Tangency and The Optimal Portfolio with three different levels of risk aversion. Optimal asset weights are determined using backward-looking estimates of expected returns and covariances, based on a rolling estimation window. In addition, the Equally Weighted and Fixed-Weight Portfolio are included. The analysis uses data from the U.S. market, covering the period from December 2009 to December 2024, with a holding period for the monthly rebalanced portfolios spanning from January 2015 to December 2024. Despite the theoretical diversification benefits suggested by the correlation analysis and periods of significant allocations within the portfolio optimization models, our results indicate that the inclusion of oil did not improve risk-adjusted performance across virtually all of the portfolio models.