Managing Diversification
Risk, pp. 74-79, May 2009

    Published On 21/03/2011
    Author Name : 
    Attilio Meucci
    Published Date: 
    Thursday, May 21, 2009
    Last Update: 
    Sunday, Mar 21, 2010

    We propose a unified, fully general methodology to analyze and act on diversification in any environment, including long-short trades in highly correlated markets with complex derivatives.

    First, we build the diversification distribution, i.e. the distribution of the uncorrelated bets in the portfolio that are consistent with the portfolio constraints. Next, we summarize the wealth of information provided by the diversification distribution into one single diversification index, the effective number of bets, based on the entropy of the diversification distribution. Then, we introduce the mean-diversification efficient frontier, a diversification approach to portfolio optimization. Finally, we describe how to perform mean-diversification optimization in practice in the presence of transaction and market impact costs, by only trading a few optimally chosen securities.

    Fully documented code illustrating our approach can be downloaded from symmys.com (sequence 7110)