Portfolio Diversification Theory

Although it may seem like common knowledge for many investors that a diversified portfolio is an excellent hedge against risk, few realize that diversification is actually explored at length in the theoretical research of economist Harry Markowitz. Through his work, Markowitz created what is officially known as modern portfolio theory, a framework for building a personal asset portfolio in which expected returns are specifically tailored to the investor's personal risk level. The Markowitz portfolio theory notes that investors will always gravitate toward reduced risk in situations where returns are constant.

Markowitz Portfolio Theory Basics

As mentioned previously, Markowitz's theory of portfolio construction relies on a single core principle – that investors are inherently risk averse. Obviously, this seems like a relatively straightforward fact. However, developing this idea leads to a series of important ideas and principles that directly relate to modern investing.

If an investor is willing to assume additional risk in their investments, Markowitz states that it will exclusively be due to an increase in the amount of expected return. Although trading risk for reward is a similar debate for all investors, Markowitz also made note that determining appropriate levels of risk would largely be an arbitrary estimate without a mathematical model to evaluate the conditions of the investment.

Portfolio Return and Portfolio Volatility

In order to effectively create a risk-expected return profile, two specific parameters must first be calculated: the expected portfolio return and portfolio volatility. These two data points are used to help assess the correlation between specific assets with regard to return and volatility alike.

According to Markowitz, two assets that have a slightly less than perfect positive correlation will present less investment risk than two assets that are perfectly correlated. This is because volatility will equally affect two perfectly correlated investments, while producing less of an impact on assets that are not identically affected by the same volatility. In essence, Markowitz's theory demonstrates how diversification – the act of selecting assets that are unequally affected by specific market volatility – will ultimately help stabilize a portfolio as a whole.

Exploring Risk-Free Assets

Markowitz's theory also explores the concept of a risk-free asset. Essentially, a risk-free asset is an investment that pays back a risk-free rate, or a rate that guarantees no financial loss over time. Perhaps the most often discussed risk-free assets are short-term government securities, which include United States Treasury bills. By incorporating risk-free assets into a portfolio, investors have extended the possible range of their specific risk-expected return investment combinations available to them.

Defining Risk in the Theory

According to Markowitz, two distinct forms of risk exist that can present themselves to investors, referred to as systematic risk and unsystematic risk. A systematic risk is one which investors have no ability to hedge against. These include massive global events such as wars, as well as unexpected economic phenomenon such as depression.

Unlike a systematic risk, an unsystematic risk is attached to a specific stock and can be actively hedged against via diversification. An example of an unsystematic risk is a change of corporate leadership, or an unanticipated downturn in profit or operation capacity. These types of "announcements" can dramatically affect the price of a stock, but they need not influence an entire portfolio to the same degree. It is in these situations where portfolio diversification is so useful.

Creating a portfolio of stocks, each of which is somewhat shielded against the unsystematic risks prevalent in the others, effectively insulates assets and ensures that negative market news doesn't lead to serious portfolio losses.

Portfolio Diversification Theory in Practice

In today's global marketplace, the modern portfolio theory remains an often employed tool by fund managers across a broad array of interests and specializations. In fact, retail investors who have adopted a more passive role in the marketplace still deploy the modern portfolio theory as a means to ensure that their holdings are not severely impacted by negative economic news at times when they are not actively managing their portfolio. Even if a single stock suffers significant losses, the diversified nature of the portfolio should help absorb this damage and ensure a stable path forward.

Modern Portfolio Theory Critics

That being said, modern portfolio theory criticism does point to a number of scenarios in which these particular ideas may seem counterintuitive or overly haphazard. For example, some investors may be turned away by the idea that actively reducing overall portfolio risk would require acquiring investment vehicles that are generally deemed high risk, such as futures contract trading.

One other perceived flaw of the modern portfolio theory is the concept that the performance of a single stock is entirely independent of other securities. Years of historical analysis have shown a high degree of interdependence and correlation between securities. This means that it may be somewhat risky for investors to fully embrace the notion that stocks with a less than perfect correlation are entirely insulated from one another's turmoil.

Finally, it is important to also realize that even investments that have been determined to present zero risk, such as U.S. Treasury Bonds, maintain a degree of instability. For example, a sharp increase in interest rates or inflation could easily diminish the value of a Treasury Bond, causing investors to quickly re-think their expected rate of return from these assets.

Portfolio Diversification Is One Variable

Ultimately, investors may continue to explore and utilize the portfolio diversification theory as long as they constantly remind themselves that it is, indeed, a theory. There are no sure bets when it comes to investing, and even the most advanced mathematical models cannot take into account the overwhelming myriad of variables that could affect the marketplace on a single day.

The portfolio diversification theory established by Markowitz remains a highly effective method of analysis, but it should always be considered one element of a larger investing toolkit rather than a one-size-fits-all solution for all investment needs. Investors who can actively balance their expectations and their reliance on this theory should find that they can develop a stable portfolio over time.

For those who may have additional questions about portfolio diversification, it is best to speak with a financial adviser before actively putting money into the marketplace. Professional finance experts can help you better understand how specific assets may contribute to your portfolio and ensure the best possible yield relative to your own tolerance for risk.