The Cost of a Free Lunch: Dabbling in Diversification

Peregrine Securities, 2015

29 Pages Posted: 22 Apr 2016 Last revised: 28 Apr 2016

See all articles by Emlyn James Flint

Emlyn James Flint

Legae Peresec; Department of Actuarial Science, University of Cape Town

Florence Chikurunhe

Peregrine Securities

Anthony Seymour

University of Cape Town (UCT)

Date Written: April 7, 2015

Abstract

It’s often said that diversification is the only ‘free lunch’ available to investors; meaning that a properly diversified portfolio reduces total risk without necessarily sacrificing expected return. However, achieving true diversification is easier said than done, especially when we don’t fully know what we mean when we’re talking about diversification. While the qualitative purpose of diversification is well-known, a satisfactory quantitative definition of portfolio diversification is not. In this report, we summarise a wide range of diversification measures, focussing our efforts on those most commonly used in practice. We categorise each measure based on which portfolio aspect it focusses on: cardinality, weights, returns, risk or higher moments. We then apply these measures to a range of South African equity indices, thus giving a diagnostic review of historical local equity diversification and, perhaps more importantly, providing a description of the investable opportunity set available to fund managers in this space. Finally, we introduce the idea of diversification profiles. These regime-dependent profiles give a much richer description of portfolio diversification than their single-value counterparts and also allow one to manage diversification proactively based on one’s view of future market conditions.

Keywords: Diversification, concentration, risk measures, regime-dependent, portfolio optimisation

JEL Classification: C14, C21, C22, C4, C5, C61

Suggested Citation

Flint, Emlyn James and Chikurunhe, Florence and Seymour, Anthony, The Cost of a Free Lunch: Dabbling in Diversification (April 7, 2015). Peregrine Securities, 2015. Available at SSRN: https://ssrn.com/abstract=2767436 or http://dx.doi.org/10.2139/ssrn.2767436

Emlyn James Flint (Contact Author)

Legae Peresec ( email )

15 Cavendish Street
Claremont
Cape Town, Western Cape 7700
South Africa
27117227556 (Phone)

HOME PAGE: http://www.legaeperesec.co.za

Department of Actuarial Science, University of Cape Town ( email )

Actuarial Science Section, University of Cape Town
Private Bag X3, Rondebosch
Cape Town, Western Cape 7701
South Africa
+27 21 650 2475 (Phone)

Florence Chikurunhe

Peregrine Securities ( email )

21 Main Road
Claremont
Cape Town, Western Cape 7700
South Africa
+27117227551 (Phone)

HOME PAGE: http://www.peregrine.co.za

Anthony Seymour

University of Cape Town (UCT) ( email )

Private Bag X3
Rondebosch, Western Cape 7701
South Africa

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