How to quantify the influence of correlations on investment diversification

When assets are correlated, benefits of investment diversification are reduced. To measure the influence of correlations on investment performance, a new quantity-the effective portfolio size-is proposed and investigated in both artificial and real situations. We show that in most cases, the effective portfolio size is much smaller than the actual number of assets in the portfolio and that it lowers even further during financial crises. © 2009 Elsevier Inc. All rights reserved