What Measures the Benefits of Diversification
19 Pages Posted: 11 Aug 2005
Date Written: May 2005
While correlation is the common indicator of the benefits of diversification, it is not a good indicator. This is for three reasons. First, diversifiable risk depends not only on the correlations between stock returns but also on the standard deviations of stock returns. Second, correlation does not provide an intuitive indicator of the benefits of diversification. Third, expected diversifiable risk, estimated from correlations and standard deviations, is biased when the distribution of the returns of stocks around the mean return of all stocks is not normal. We know diversifiable risk as unsystematic risk, tracking error and dispersion. We analyze diversifiable risk in portfolios of U.S. stocks during 1980-2004.
Keywords: Diversification, correlations, dispersion, tracking errors, portfolio theory
JEL Classification: G11, G14
Suggested Citation: Suggested Citation