A portfolio diversification measure in the unit interval: A coherent and practical approach

Abstract

In this article, we introduce and examine the efficiency of a portfolio diversification measure. Using the recently developed coherence properties for diversification measures as well as other criteria, we show that the novel measure outperforms the most commonly used diversification measures. Although similar in shape to other measures, our measure is the only one that satisfies all nine coherence properties whilst being easily interpreted. After testing interpretability and coherence for all measures, we perform an empirical analysis divided into two main parts. In the first part, we test some common diversification measures in a Gaussian context and in the second part we consider three empirical portfolios during the COVID‐19 pandemic. We establish the efficiency of our measure in capturing the changing level of diversification in empirical portfolios. We believe these results imply a competitive advantage for our measure and make it relevant for econometricians, practitioners and decision‐makers in general in a portfolio optimisation context.