22 Pages Posted: 15 Oct 2004
Date Written: October 2004
Correlation is the common measure of the benefits of diversification, but dispersion, measured as the standard deviation of the returns of stocks around the mean of all stocks, is better. 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. Dispersion accounts for both. Second, dispersion provides an intuitive measure of the benefits of diversification while correlation does not. We show the relationship between dispersion, correlation and standard deviation and analyze the dispersion of U.S. stocks during 1980-2003.
Keywords: Behavioral finance, diversification, correlation, dispersion, portfolio theory
JEL Classification: G11, G12
Suggested Citation: Suggested Citation