EFFICIENCY OF DIVERSIFICATION

EFFICIENCY OF DIVERSIFICATION

EFFICIENCY OF DIVERSIFICATION

EFFICIENCY OF DIVERSIFICATION

According to modern portfolio theory, investors on the average can not expect to be compensated for incurring avoidable risk. If all investors believe that markets are efficient and understand the portfoliotheory of Markowitz and Sharpe, all will seek to hold highly diversifiedportfolios which, by definition, have eliminated avoidable risk. Thisis equivalent to saying that all investors will hold portfolios whichare perfectly correlated with very general market indexes so that fluctuations in the value of portfolios will be determined solely by generalmarket movements.

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Opportunities for superior or inferior performance are made possible only by departures from that theoretical goal. Naturally, any portfolio which is perfectly correlated with the market will lie on the capital market line and its manager will be judged to be neither inferior nor superior by reference to that bench mark. Imperfect correlation(i.e., the existence of avoidable risk) provides opportunities for successor failure. We are not interested here in judging success or failure,but rather in understanding its causes. If a portfolio consistently liesabove the capital market line, there are a number of possible causessuch as adeptness in switching from equities to fixed-dollar assets and back, or superiority in picking assets within each class. The latter willinevitably be accompanied by correlations with the market significantly below 1.0. More often such departures from perfect correlationswill be accompanied by inferior performance and will be one plausibleexplanation of it. True believers in efficient markets will insist uponefficient diversification (high correlations with the market) and willfind that goal easy to achieve.

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