Modern portfolio theory and diversification

¶ … Diversification

Portfolio diversification as a form of risk management is one of the cornerstones of modern investment theory. According to the theory, the ideally-diversified portfolio is 'deeply diversified' within each asset class and also 'broadly diversified' across all the asset classes within the portfolio (Simon 2010:2). Asset classes consist of "stocks, bonds, real estate, commodities, precious metals and collectibles;" forms of market capitalization (micro-, small-, mid- and large-cap); style; sectors; industry types; and geography (Portfolio diversification, 2012, Investing in mutual funds). The objective of diversification is that "risk has virtually been eliminated within each class" by combining lower and higher-risk assets (Portfolio diversification, 2012, Investing in mutual funds). Theoretically, the perfectly diversified portfolio should incur no additional risks to the investor greater than what is posed by the general market conditions. There is always risk in investment, but portfolio management is designed to minimize the risk.

To achieve this objective, modern portfolio theory uses the Efficient Frontier model, which is based upon a "simple geometric graph of the trade-off between risk and return. The frontier itself is a composition of many portfolios, Portfolios on the frontier provide a return to risk premium over any of the assets that combine to create the portfolios." (Portfolio theory, 2010, Gravity Investments). The Efficient Frontier model was so revolutionary because "rather than accepting two variables, risk and return, it incorporates a trans-dimensional factor: diversification. Diversification optimization assigns each asset a vector by locating each vector in a direction that best explains the correlation with the rest of the assets. The vector lengths are set to a utility function, usually including both risk and return, such as the Sharpe Ratio, Calmar Ratio or Sortino Ratio" (Portfolio theory, 2010, Gravity Investments). The Sharpe Ratio "measures return over volatility" while the Sortino Ratio is used to "differentiate between good and bad volatility in the Sharpe ratio" (Sharpe end of the measuring stick, 2011, Attain Cap; Sortino ratio definition, 2012, Investopedia). The Calmar Ratio is used to measure "return relative to drawdown (downside) risk" (Sharpe end of the measuring stick, 2011, Attain Capital).

One example of how portfolio diversification is applied is manifested in the desirability of being diversified across a wide array of countries. "A portfolio invested 50% in domestic large-cap stocks and 50% in international large-cap stocks would have approximately half the residual risk of a portfolio comprised solely of domestic large-cap stocks, assuming that the investments in each market were sufficiently diversified to eliminate specific risk" (Portfolio theory, 2010, Gravity Investments). Theoretically, a rational investor will not seek out more risk, even if there is a chance of greater returns, because seeking out such greater risk is deemed to be gambling, which is inherently irrational (Portfolio theory, 2010, Gravity Investments).

Modern portfolio theory was subjected to a great deal of scrutiny in the wake of the 2008 credit crisis because the effects were so far-reaching. "One 'prediction' made by MPT is that in (inevitable) market downturns, a well-diversified portfolio will perform relatively better than a concentrated, non-diversified portfolio" although avoiding risk altogether is impossible when one is investing (Simon 2010:1). A portfolio with a heavy emphasis on financial stock and real estate assets would have done particularly poorly during the recent financial crisis. A portfolio with a strong emphasis on European companies might be struggling now, because of uncertainty about the future of the Euro Zone. With diversification, in theory, although a portfolio might not be perfectly protected against a possible blow to one economic sector (such as investors who were not invested in real estate at all in 2008, for example), diversification ensures that even in the most unpredictable economic times there is the potential for some self-protection.

Another criticism of portfolio diversification is that it is not suitable for all investors. "While a given mix of investments may be appropriate for a child's college education fund," which is not expected to grow very much, "that mix may not be a good match for long-term goals, such as retirement or estate planning. Likewise, investors with large sums of money often require strategies designed to address more complex needs, such as minimizing capital gains taxes or generating reliable income streams" (Introduction to investment diversification, 2012, Investopedia). Also, an over-diversified portfolio may dilute potential gains from profitable sectors and cause the portfolio to behave more like a passively-managed index fund.

Thus, diversification has its critics. The idea that it is best to 'watch' one's assets rather than diversify is most famously espoused by Warren Buffet, the legendary owner of Berkshire Hathaway. Of Berkshire Hathaway's investment strategy Buffet said: "We diversify substantially less than most investment operations. We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment" (Buffett 1966). In Buffet's view, intelligent investments, carefully watched and strategized, are better than amassing a large array of investments, given the more investments one has, the more difficult it is to keep track of the portfolio.