Enter the portfolio volatility and the weighted average volatility of individual assets into the calculator to determine the diversification ratio.
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Diversification Ratio Formula
The following formula is used to calculate the diversification ratio for a given portfolio.
DR = \frac{WAV}{PV}Variables:
- DR is the diversification ratio
- PV is the portfolio volatility
- WAV is the weighted average volatility of individual assets
To calculate the diversification ratio, divide the weighted average volatility of the individual assets by the portfolio volatility. This ratio helps in understanding the risk reduction achieved through diversification.
What is a Diversification Ratio?
The diversification ratio is a measure used in portfolio management to assess the benefits of diversification. It is calculated by dividing the weighted average volatility of the individual assets within the portfolio by the portfolio volatility. A higher diversification ratio indicates a greater reduction in risk due to diversification. This metric helps investors understand how much risk reduction is achieved by holding a diversified portfolio compared to holding individual assets.
How to Calculate Diversification Ratio?
The following steps outline how to calculate the Diversification Ratio.
- First, determine the portfolio volatility (PV).
- Next, determine the weighted average volatility of individual assets (WAV).
- Finally, calculate the diversification ratio using the formula DR = WAV / PV.
- After inserting the values and calculating the result, check your answer with the calculator above.
Example Problem :
Use the following variables as an example problem to test your knowledge.
Portfolio Volatility (PV) = 0.15 (15%)
Weighted Average Volatility of Individual Assets (WAV) = 0.25 (25%). Diversification Ratio (DR) = WAV / PV = 0.25 / 0.15 ≈ 1.6667.