Diversification & Asset Allocation

• Return is the reward that investors expect for being exposed to investment risk. As such, the return must be commensurate with the level of investment risk. Thus returns are meaningless when not taken in context with the attendant risks.
• In a well-diversified portfolio of individual securities, the risk of a total loss should not be a concern, but individual securities in a portfolio can become worthless, thus having a negative impact on portfolio return.
• In a well-diversified portfolio of mutual funds, diversification is so complete that the bankruptcy of a single company in one of the mutual funds will not have a material effect on the portfolio. In other words, virtually 100% of company-specific risk has been diversified away.

• Diversification is analogous to not putting all of your eggs in one basket.
• Diversification provides the means to minimize investment risk.
• The objective of every investor is to achieve the highest return possible at the level of risk that is consistent with their personal level of risk aversion.
• As substantially different assets are added to a portfolio the total risk of the portfolio decreases.
• An investment universe consists of all the assets in a given set of asset classes.
• Investors' opportunities to diversify are limited by their selection of a universe.
• Thus the asset classes that represent all of the publicly traded assets worldwide should be considered when selecting an investment universe.
• For any investment universe, there is an optimal set of assets for every level of risk.
• The optimal set of assets will provide the highest possible return for a given level of risk within that universe.
• Such optimization is said to be mean-variance efficient, or simply efficient.
• There is also one set of assets in every universe that dominates all others on a mean-variance basis. This portfolio is the optimal risky portfolio.
• In general, the broader the universe, the higher the rate of return achievable at any given level of risk, although this does have its limits.
• The correlation between assets determines the number of substantially different assets required to achieve the optimal balance between risk and return.
• The lower the correlation between assets, the fewer the assets required to achieve efficiency.
• Investors should strive to allocate their capital to the assets in their universe that will result in the construction an efficient portfolio at the level of risk that is right for them. This can be accomplished in two ways:
  1. Assemble a portfolio that is efficient at the desired level of risk.
  2. Construct the optimal risky portfolio and adjust the risk by either investing a portion in T-Bills to lower the risk or buying more of the risky portfolio on margin to increase the risk. This is superior to the first option but a bit more complex.

• Portfolio Diversification
• Asset Allocation
• The Efficient Frontier
• Correlation
• Investment Risk
• Time Diversification - Not as Good as it Sounds
• Dealing with Terminal Wealth Dispersion