Diversification

Diversification has been described as the only “free lunch” in the investment world. The benefits of diversification owe to the fact that asset prices tend not to move in perfect unison. Some are zigging while others zag. Correlation is used to measure the degree to which the prices of two assets move together. Anything less than perfectly positive co-movement between two assets (a correlation less than 1) means there will be diversification benefits from their combination.

Diversification is widely regarded as a cornerstone of prudent investment management. It forms the core of Modern Portfolio Theory (MPT), derived from the work of Harry Markowitz in "Portfolio Selection," which appeared in the 1952 Journal of Finance. In an extension of this work, Bill Sharpe created the Capital Asset Pricing Model (CAPM), which states that risk that can be eliminated through the holding of multiple asset - diversified away - is not compensated by the markets. Instead, investors are only compensated for assuming systematic, or non-diversifiable risk.

In an asset allocation context, the benefits of diversification are further enhanced with a program of periodic rebalancing. In the absence of any changes to the long-term strategic asset allocation, the exercise of rebalancing will result in selling those asset classes that have appreciated in value, and purchasing those that have declined. All else being equal the risk return tradeoff becomes less attractive as prices increase, and rebalancing is required to restore the desired positioning. Aside from maintaining the target allocation, this value-oriented process – selling high and buying low - tends to add incremental return over time.