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How to quantify the influence of correlations on investment diversification

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  • Medo, Matús
  • Yeung, Chi Ho
  • Zhang, Yi-Cheng
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    Abstract

    When assets are correlated, benefits of investment diversification are reduced. To measure the influence of correlations on investment performance, a new quantity--the effective portfolio size--is proposed and investigated in both artificial and real situations. We show that in most cases, the effective portfolio size is much smaller than the actual number of assets in the portfolio and that it lowers even further during financial crises.

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    Bibliographic Info

    Article provided by Elsevier in its journal International Review of Financial Analysis.

    Volume (Year): 18 (2009)
    Issue (Month): 1-2 (March)
    Pages: 34-39

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    Handle: RePEc:eee:finana:v:18:y:2009:i:1-2:p:34-39

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    Web page: http://www.elsevier.com/locate/inca/620166

    Related research

    Keywords: Mean-Variance portfolio Kelly portfolio Diversification Correlations;

    References

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    1. Smimou, K. & Bector, C.R. & Jacoby, G., 2008. "Portfolio selection subject to experts' judgments," International Review of Financial Analysis, Elsevier, vol. 17(5), pages 1036-1054, December.
    2. Paolo Laureti & Matus Medo & Yi-Cheng Zhang, 2007. "Analysis of Kelly-optimal portfolios," Papers 0712.2771, arXiv.org, revised Apr 2009.
    3. Laurent Laloux & Pierre Cizeau & Jean-Philippe Bouchaud & Marc Potters, 1998. "Noise dressing of financial correlation matrices," Science & Finance (CFM) working paper archive 500051, Science & Finance, Capital Fund Management.
    4. Myron S. Scholes, 2000. "Crisis and Risk Management," American Economic Review, American Economic Association, vol. 90(2), pages 17-21, May.
    5. Medo, Matúš & Pis’mak, Yury M. & Zhang, Yi-Cheng, 2008. "Diversification and limited information in the Kelly game," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 387(24), pages 6151-6158.
    6. Valery Polkovnichenko, 2005. "Household Portfolio Diversification: A Case for Rank-Dependent Preferences," Review of Financial Studies, Society for Financial Studies, vol. 18(4), pages 1467-1502.
    7. Elton, Edwin J & Gruber, Martin J, 1977. "Risk Reduction and Portfolio Size: An Analytical Solution," The Journal of Business, University of Chicago Press, vol. 50(4), pages 415-37, October.
    8. Merton, Robert C., 1972. "An Analytic Derivation of the Efficient Portfolio Frontier," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 7(04), pages 1851-1872, September.
    9. John Lintner, 1965. "Security Prices, Risk, And Maximal Gains From Diversification," Journal of Finance, American Finance Association, vol. 20(4), pages 587-615, December.
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    11. Chris Whitrow, 2007. "Algorithms for optimal allocation of bets on many simultaneous events," Journal of the Royal Statistical Society Series C, Royal Statistical Society, vol. 56(5), pages 607-623.
    12. Jorion, Philippe, 1985. "International Portfolio Diversification with Estimation Risk," The Journal of Business, University of Chicago Press, vol. 58(3), pages 259-78, July.
    13. Markowitz, Harry M, 1976. "Investment for the Long Run: New Evidence for an Old Rule," Journal of Finance, American Finance Association, vol. 31(5), pages 1273-86, December.
    14. Meric, Ilhan & Ratner, Mitchell & Meric, Gulser, 2008. "Co-movements of sector index returns in the world's major stock markets in bull and bear markets: Portfolio diversification implications," International Review of Financial Analysis, Elsevier, vol. 17(1), pages 156-177.
    15. Statman, Meir, 1987. "How Many Stocks Make a Diversified Portfolio?," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 22(03), pages 353-363, September.
    16. Matus Medo & Yury M. Pis'mak & Yi-Cheng Zhang, 2008. "Diversification and limited information in the Kelly game," Papers 0803.1364, arXiv.org, revised Jul 2008.
    17. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, 03.
    18. Heston, Steven L. & Rouwenhorst, K. Geert, 1994. "Does industrial structure explain the benefits of international diversification?," Journal of Financial Economics, Elsevier, vol. 36(1), pages 3-27, August.
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