Chapter 8Asset Diversification

The concepts of portfolio risk management and diversification have been instrumental in the development of modern financial decision making. These breakthrough ideas originated in an article by Harry Markowitz that appeared in 1952. Before Markowitz's publication, the focus in the investment industry was on identifying and investing in “winners”—stocks that appear undervalued relative to some measure of their potential or promise sustainable growth, that is, stocks with high expected returns. Markowitz reasoned that investors should decide based on both the expected return from their investment, and the risk from that investment. He defined risk as the variance of future returns. The idea of incorporating risk in investment decisions and applying a disciplined quantitative framework to investment management was novel at the time.1 Originally, this investment philosophy generated little interest, but eventually, the finance community adopted it. Over the years, the theory of portfolio selection formulated by Markowitz has been extended and reinvented based on a modification of the assumptions made in the original model that limited its application. It has also introduced a whole new terminology, which is now the norm in the investment management community. Markowitz's investment theory is popularly referred to as mean-variance analysis, mean-variance portfolio optimization, and Modern Portfolio Theory (MPT). In 1990, Markowitz was awarded the Nobel ...

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