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Asked & Answered: Measuring Diversification

June 23, 2011

 

Laverne from Lafayette, PA:

 

Can I measure the level of diversification in my portfolio?

 

Friedenthal Financial:

 

That’s an excellent question!  While we are not aware of a universally accepted formula for diversification, we can share the methods that we use.

 

First let’s specifically define the task.  When we combine more than one asset, how does the expected volatility of the combined portfolio differ from the sum of the parts?  Diversification is a measure of risk reduction achieved by combining assets that are different from each other.  Let’s look at two stocks that have an expected return of 10% with a standard deviation of 20% (meaning about 68% of the time the returns will be +/- 20% from the expectation…..thus between -10% and +30%).  By combining them in a portfolio together, the expected return is still 10%, but the deviation will decline to something below 20%.  How much risk reduction is achieved will be determined by how different the two stocks are from each other.  The lower the correlation between the two stocks, the more diversification they achieve.  Thus the more diverse our portfolio components are, the greater the reduction in risk, for no reduction in expected return.  This is why diversification is considered the only free lunch (financially speaking).

 

Even though the S&P500 is considered well diversified already (since it is comprised of 500 stocks), you can still increase your diversification materially by combining other asset classes.  By adding a variety of equity, credit, and traditional fixed income, across multiple currencies, a portfolio can achieve maximum diversification.  We measure our diversification by comparing the combined portfolio deviation to the average deviation of the components.  Please keep in mind that if you are starting with components that are already diversified (such as an ETF or mutual fund that owns the S&P500) the incremental diversification associated with their combination will be lower than if you start with the individual stocks in each component.  So, learn to look at diversification as something of a relative statistic.

Please click here to download a spreadsheet with an example of portfolio diversification.

 

Spreadsheet Explanation:

 

When we look at the 30 stocks in the Dow Jones, we see that the average standard deviation is 22.7%. This is simply the average and not the combination. By combining those same 30 stocks into a portfolio (equally weighted for simplicity) we get a standard deviation of 15.7%. This illustrates that you get a 30.8% reduction (1-15.7%/22.7%) in standard deviation by combining these 30 stocks into one portfolio.

 

To take this one step further, we assembled a list of 8 asset classes with an average standard deviation equal to the standard deviation of the S&P 500 (16.3%). By combining these asset classes into a portfolio (again, equally weighted), we get a standard deviation of 14.3%. So we can say that by combining an index of large cap, US stocks with 7 other asset classes, we can remove unnecessary volatility of the portfolio by another 12.2% (1-14.3%/16.3%).

 

If you are looking closely, you might notice that the standard deviation of the S&P is higher than the combination of the Dow 30 stocks and wonder how this is possible given the number of stocks in the S&P 500. This is due to the 30 stocks in the Dow being large-cap blue chip stocks that tend to have lower volatility than many of the stocks the make up the S&P 500.

 

If you have any questions or would like to discuss this concept further, please feel free to give us a call. This topic can be challenging and we are happy to explain in more detail.

 

We hope that helps and provides fodder for discussion.  Please let us know if we can be of further service!

 

The Friedenthal Financial Team

856-210-6494 (Office)

856-210-1565 (Facsimile)

info@friedenthalfinancial.com

www.friedenthalfinancial.com

 

Please send us your questions!!   If we don’t know the answers, we’ll find someone who does!

 

If you know someone who would like to discuss their investment needs with us, we certainly appreciate the introduction.

 

This blog is only intended to provide answers to questions of general interest we receive on the topics of investments, finance, capital markets, and economics and to serve as a historical repository for our e-mailed Asked & Answered column.  We are not rendering or offering to render personalized investment advice or financial planning advice through this blog or any of its attached links.  Friedenthal Financial will render investment advice to potential clients only after:  (i) we have delivered a disclosure statement to the potential client as required under applicable securities laws, and (ii) the potential client has executed and delivered Friedenthal Financial’s investment advisory contract to us.  We will provide investment advisory services to clients only in states in which Friedenthal Financial is registered as an investment adviser or is exempt from registration.