Where is the Metric for Diversity?
“What gets measured, gets managed.” – Peter Drucker
It seems that while diversification is widely touted as the fundamental principle behind insurance and behind risk management in general, there is no general measure of diversity. So based upon Drucker’s rule of thumb RISKVIEWS would say that we all fail to manage diversity.
A measure of diversity would tell us when we take more similar risks and when we are taking more distinct risks. But we do not even look.
This may well be another part of good financial management that has been stolen by the presumptions of financial economics. Financial economics PRESUMES that we all have full diversification. It tells us that we cannot get paid for our lack of diversification.
But those presumptions are untested and untestable, at least as long as we fail to even measure diversity.
Correlation is the best measure that we have and it is barely used. For the most part, correlation is used mainly to look at macro portfolio effects on Economic Capital Models. And it is not a particularly good measure of diversity anyway. It actually only measures a certain type of statistical comovement of data. For example, below is a chart that shows that equity market comovement is increasing.
But have the activities of the largest companies in those markets been converging? Or is this picture just an artifact of the continuing Euro crisis? In either case, if we were looking at a measure of diversity, rather than just comovement, we might have an idea whether this chart makes any sense or not.
Many believe that they are protected by indexing. That an index is automatically diverse. But there is little guarantee of that. Particularly for a market-value weighted index. In fact, a market-values weighted index is almost guaranteed to have less diversity just when it is needed most.
For a clear indication of that look at the TSX index during the internet bubble Nortel represented 35% of the index! Concentration increases risk. In this case, the results were disastrous for any indexers. While Nortel stock rose in the Dot Com mania, buyers of the TSX index were holding a larger and larger fraction of their investment in a single stock.
We badly need a metric for diversity.