Measuring Portfolio Diversification is Not Easy

In this research brief we explore the pitfalls in measuring portfolio diversification in private capital. To this end we examine two very different methodologies -  temporal diversification and cross-sectional diversification - and discuss the shortcomings of each. In particular, we show two things: first, how temporal diversification makes it hard to identify cross-sectional diversification; second, how econometric challenges make time-series approaches problematic.

Diversification allows investors to reduce their risk without compromising their expected returns by allowing the specific risks of a wide variety of investments to cancel out. In the public markets it is straightforward to show that the risk of a portfolio can be reduced (as a result of diversification) by distributing its capital among different securities. While we don’t believe private capital to be any different in this regard, in this research brief we are primarily interested in quantifying this effect for private capital portfolios.

Private Capital Combines Two Different Types Of Diversification – Cross-Sectional And Temporal – Complicating Its Analysis