Abstract

This paper introduces an on-line mechanism for updating portfolio allocations driven by systemic risk, aiming to maximize both the average portfolio return and the modified Sharp ratio (MSR). The proposed mechanism includes three systemic risk-based critical components: a novel real-time monitoring test based on multiple differenced (MD) principles to timely adjust allocations, two easy-to use momentum investment strategies, and two straightforward cross-asset risk-weighting schemes. We also propose a modified Sharp ratio (MSR) for enhanced portfolio evaluation. Simulation results demonstrate that our monitoring test effectively minimizes size distortion and maintains robust power, reducing the impact of spurious breaks and spurious correlations while mitigating losses from unnecessary portfolio adjustments. The practical application of this mechanism is validated through three global country-specific portfolios formed over the period from January 1994 to November 2023, encompassing several significant extreme events. Empirical findings reveal that detecting breaks in the systemic risk can not be ignored in a portfolio selection procedure, because our updating procedure can achieve up to 60 % higher average portfolio returns and deliver a superior modified information ratio when compared to existing procedures which do not consider systemic risks.