“Diversification is bothobserved and sensible; a rule of behaviour which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim,” wrote Harry Markowitz, a prodigiously talented young economist, in the Journal of Finance in 1952. The paper, which helped him win the Nobel prize in 1990, laid the foundations for “modern portfolio theory”, a mathematical framework for choosing an optimal spread of assets.
The theory posits that a rational investor should maximise his or her returns relative to the risk (the volatility in returns) they are taking. It follows, naturally, that assets with high and dependable returns should feature heavily in a sensible portfolio. But Mr Markowitz’s genius was in showing that diversification can reduce volatility without sacrificing returns
Diversification is the financial version of the idiom “the whole is greater than the sum of its parts.”
