For anyone who has done some reading on investment risk management, you’ve very likely come across portfolio diversification. The goal of portfolio diversification is to create a portfolio of investments that have low volatility. That means the value of the portfolio should not fluctuate as much as a similar non-diversified portfolio.
Creating a diversified portfolio involves choosing uncorrelated assets and weighting them across the portfolio. But how exactly do you measure the degree to which a portfolio is diversified? In this article, we’ll explore what goes into measuring diversification in a portfolio.
Start with the Appropriate Ingredients
A diversified portfolio consists of uncorrelated assets. This simply means that the price of two assets does not move together. Two assets can have the same volatility, but if they are uncorrelated, their average volatility is lower than that of each individual asset.
When creating a diversified portfolio, it is widely accepted that after 30 assets, there are diminishing returns in diversification. In other words, adding more than 30 assets will do little to improve the portfolio’s diversification.
A correlation coefficient is a number that ranges from -1 to +1. A negative one means the price of two assets move in opposite directions, while a positive one means they move in sync. Uncorrelated assets are those with values of less than one.
Volatility is measured through standard deviation. Standard deviation measures how much daily price changes in an asset move away from the price’s mean during a specific period.
Weighting is the percentage of the portfolio’s value consumed by a single asset. Assets are weighted so that one asset doesn’t adversely impact a portfolio. For example, Asset A may be weighted 10% and Asset B weighted 10%, rather than A at 90% and B at 10%.
Using correlation, standard deviation, and weighting, portfolio analysis software is able to produce measurements of diversification. This software is something your financial adviser likely uses. Also, many robo advisers use some form of diversification measuring software.
Measuring Portfolio Diversification
Now to the main question — how do we measure diversification within a portfolio? Once you have uncorrelated assets weighted in a portfolio, you need some metric that can provide an overall diversification number.
A very manual method of measurement is to download a years’ worth of historical prices for the various assets in a portfolio. Load that data into a spreadsheet and run calculations for standard deviation and correlation on it. That’s a very tedious and complex route.
As mentioned above, there’s software available to handle the heavy lifting involved with measuring portfolio diversification. If you aren’t using a robo adviser, work with your financial adviser to understand how diversified your portfolio is.
Your financial adviser will let you know which assets might be too correlated or overweighted, how much excessive risk the portfolio might be taking on, and its level of volatility compared to a similar portfolio. All of these measurements should align with your financial goals and timelines.
Measuring a portfolio's diversification is a complex topic. Unless you have experience in this area, it's best to seek a financial professional's help.
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