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How to quantify the influence of correlations on investment diversification

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Author Info
Matus Medo
Chi Ho Yeung
Yi-Cheng Zhang
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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File URL: http://arxiv.org/abs/0805.3397
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File URL: http://arxiv.org/pdf/0805.3397
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Paper provided by arXiv.org in its series Quantitative Finance Papers with number 0805.3397.

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Date of creation: May 2008
Date of revision: Feb 2009
Publication status: Published in International Review of Financial Analysis 18, 34-39 (2009)
Handle: RePEc:arx:papers:0805.3397

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Elton, Edwin J & Gruber, Martin J, 1977. "Risk Reduction and Portfolio Size: An Analytical Solution," Journal of Business, University of Chicago Press, vol. 50(4), pages 415-37, October. [Downloadable!] (restricted)
  2. 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. [Downloadable!] (restricted)
  3. 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. [Downloadable!]
  4. Jorion, Philippe, 1985. "International Portfolio Diversification with Estimation Risk," Journal of Business, University of Chicago Press, vol. 58(3), pages 259-78, July. [Downloadable!] (restricted)
  5. Myron S. Scholes, 2000. "Crisis and Risk Management," American Economic Review, American Economic Association, vol. 90(2), pages 17-21, May. [Downloadable!] (restricted)
  6. 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. [Downloadable!]
  7. 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. [Downloadable!] (restricted)
  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. [Downloadable!]
  9. 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. [Downloadable!] (restricted)
  10. Matus Medo & Yury M. Pis'mak & Yi-Cheng Zhang, 2008. "Diversification and limited information in the Kelly game," Quantitative Finance Papers 0803.1364, arXiv.org, revised Jul 2008. [Downloadable!]
  11. Olibe, Kingsley O. & Michello, Franklin A. & Thorne, Jerry, 2008. "Systematic risk and international diversification: An empirical perspective," International Review of Financial Analysis, Elsevier, vol. 17(4), pages 681-698, September. [Downloadable!] (restricted)
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This page was last updated on 2009-12-4.

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