Diversification and asset allocation

Intuitively, we all know that diversification is important for managing investment risk. But how exactly does diversification work, and how can we be sure we have an efficiently diversified portfolio? Insightful answers can be gleaned from the modern theory of diversification and asset allocation. In this chapter, we examine the role of diversification and asset allocation in investing. Most of us have a strong sense that diversification is important. After all, " Don't put all your eggs in one basket " is a bit of folk wisdom that seems to have stood the test of time quite well. Even so, the importance of diversification has not always been well understood. For example, noted author and market analyst Mark Twain recommended: " Put all your eggs in the one basket and—WATCH THAT BASKET! " This chapter shows why this was probably not Twain's best piece of advice. 1 As we will see, diversification has a profound effect on portfolio risk and return. The role and impact of diversification were first formally explained in the early 1950's by financial pioneer Harry Markowitz, who shared the 1986 Nobel Prize in Economics for his insights. The primary goal of this chapter is to explain and explore the implications of Markowitz's remarkable discovery.