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

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.
The indicator which indicates that a portfolio has been diversified properly is a decrease in the
standard deviation(SD) of the portfolio.
A SD is a risk measure that indicates the deviation from the expected returns. Beta is a market
sensitivity measure that is unrelated to diversified risk. With effective diversification, one can
reduce the risk. That indicates the reduction in SD of the portfolio.