Quantifying the Skewness Loss of Diversification

Volume 17, No. 2, 2019
James X. Xiong and Thomas M. Idzorek

Diversification is widely viewed as the “only free lunch” of finance. Unbeknownst to the free lunch crowd, skewness is typically positive for individual stocks and negative for diversified portfolios and thus diversification is not free. This undesirable move from positive to negative skewness that comes with diversification is the skewness loss of diversification. We quantify the economic value of skewness loss using option pricing models, and show that skewness loss is a meaningful cost for investors with skewness preferences and short horizons.