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Diversification is the concept of lowered risk when securities are held in a portfolio. Securities with low correlation, or co-movements, offer greater diversification benefits. The quantification of this lowered risk can be forecast by using portfolio weights and the risk measures found in a covariance matrix.
Synonym: Risk Spreading
For context, to quantify the free risk-reduction benefit of diversification requires the creation of a stock-by-stock or factor-based covariance matrix. These matrices are computed using large samples of past values of assets to see if they co-vary, or move in tandem over time. The mathematical computing power needed to pull of such an estimate over thousands of securities explains why advancements in Modern Portfolio Theory (MPT) took time to be implemented.
Guy: How do you measure diversification when
executing your daily trade lists?
Rex: By instinct. How much did you spend at lunch today Guy? $6.73 or $6.74?
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Still unclear on the term Diversification? Check out the Quant 101 Series with a deep-dive in Excel where we walk through examples of diversifying portfolio risk.
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