The Limitations of Diversification Return

Abstract

Diversification return is the amount by which the geometric mean return (i.e., average compounded return) of a portfolio exceeds the weighted average of the geometric means of the portfolio’s constituent assets. Diversification return has been touted as a source of added return, even if markets are informationally efficient. Portfolio rebalancing has been advocated as a valuable source of diversification return. The authors demonstrate that diversification return is not a source of increased expected value. However, portfolio rebalancing can be an effective mean-reverting strategy. Any enhanced expected value from rebalancing emanates from mean-reversion, rather than from diversification or variance reduction.