How to quantify the influence of correlations on investment diversification

TL;DR

This paper introduces the effective portfolio size, a new metric to quantify how asset correlations diminish diversification benefits, showing it often significantly underestimates true diversification especially during crises.

Contribution

The paper proposes and investigates the effective portfolio size as a novel measure to assess the impact of correlations on diversification in both artificial and real markets.

Findings

Effective portfolio size is usually much smaller than the actual number of assets.

Correlations cause the effective portfolio size to decrease, especially during financial crises.

The measure provides insights into the true diversification level in portfolios.

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.