|
Diversification is a measure of the commonality of a population. Greater diversification denotes a wider variety of elements within that population. Diversification is of central importance in investments. Diversification reduces the risk of a portfolio. It does not necessarily reduce the returns. This is why diversification is referred to as the only free lunch in finance.
Diversification can be quantified as the intra-portfolio correlation. This is a statistical measurement from negative one to one that measures the degree to which the various assets in a portfolio can be expected to perform in a similar fashion.
Intra-portfolio correlation |
Percent of diversifiable risk eliminated |
1
|
0% |
0.75 |
12.5% |
0.5 |
25% |
0.25 |
37.5% |
0 |
50% |
-0.25 |
62.5% |
-0.5 |
75% |
-0.75 |
87.5% |
-1 |
100% |
Portfolio balance occurs as the sum of all intra-portfolio correlations approaches negative one. Diversification is thus defined as the intra-portfolio correlation or, more specifically, the weighted average intra-portfolio correlation. Maximum diversification occurs when the intra-portfolio correlation is minimized. Intra-portfolio correlation may be an effective risk management measurement.
|
