Home > Diversification
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%
|
| .75 | 12.5%
|
| .50 | 25%
|
| .25 | 37.5%
|
| 0 | 50%
|
| -.25 | 62.5%
|
| -.50 | 75%
|
| -.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. The computation may be expressed as:
-
Where Q is the intra-portfolio correlation,
is the fraction invested in asset i,
is the fraction invested in asset j,
is the correlation between assets i and j, and
n is the number of different assets.
See also
