The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

PORTFOLIO DIVERSIFICATION

Often, one hears investors talking about diversifying their portfolio. By this an investor means constructing a portfolio in such a way as to reduce portfolio risk without sacrificing return. This is certainly a goal that investors should seek. However, the question is how to do this in practice.

Some investors would say that including assets across all asset classes could diversify a portfolio. For example, a investor might argue that a portfolio should be diversified by investing in stocks, bonds, and real estate. While that might be reasonable, two questions must be addressed in order to construct a diversified portfolio. First, how much should be invested in each asset class? Should 40% of the portfolio be in stocks, 50% in bonds, and 10% in real estate, or is some other allocation more appropriate? Second, given the allocation, which specific stocks, bonds, and real estate should the investor select?

Some investors who focus only on one asset class such as common stock argue that such portfolios should also be diversified. By this they mean that an investor should not place all funds in the stock of one corporation, but rather should include stocks of many corporations. Here, too, several questions must be answered in order to construct a diversified portfolio. First, which corporations should be represented in the portfolio? Second, how much of the portfolio should be allocated to the stocks of each corporation?

Prior to the development of ...