Chapter Four

Diversification, Portfolios of Risky Assets, and the Efficient Frontier

Diversify your investments.

—John Templeton

Portfolio diversification is a widely embraced investment strategy that reduces your portfolio investment risk. Simply stated, by combining assets that are not perfectly correlated—that is, do not move in perfect lock-step together—the risks embedded in a portfolio are lowered and higher risk-adjusted returns can be achieved. The lower the correlation between assets, the greater the reduction in risk that can be derived. Modern Portfolio Theory was first developed with individual securities in mind but can also be applied to combinations of asset classes.

To understand the benefits of global diversification, it is useful to separate the risk of investments into two broad types, security-specific risks and market risks. Security-specific risks result from factors specific to the security, such as management skill at a corporation. Security-specific risks can be almost eliminated by gaining an exposure to a whole asset class. Market risk results from factors that impact on groups of securities or a whole asset class, such as interest rates or macroeconomic factors like the business cycle. By diversifying between asset classes, we can reduce market risk; and because of different economic factors between countries, global diversification can reduce these risks even further. The benefits of global diversification are illustrated in Figure 4.1, which considers ...

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