Measuring the Benefits of Diversification and the Performance of Money Managers

Abstract

While correlation is the common measure of the benefits of diversification, it is not a good measure. This is for two reasons. First, the benefits of diversification depend not only on the correlations between stock returns but also on the standard deviations of stock returns. Second, correlation does not provide an intuitive measure of the benefits of diversification. Dispersion is a better measure of the benefits of diversification. Dispersion is the standard deviation of the returns of stocks around the mean return of all stocks. We know dispersion as diversifiable risk and as tracking error. We analyzed the returns of the S&P 500 stocks during the years 1980–2004 to show how dispersion measures the benefits of diversification and how to account for dispersion in the assessment of the performance of money managers.

Keywords: Diversification, Correlations, Dispersion, Tracking Errors, Portfolio Theory

JEL Classification: G11, G14