Diversification and portfolio theory: a review
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Diversification and portfolio theory: a review Gilles Boevi Koumou1,2
© Swiss Society for Financial Market Research 2020
Abstract Diversification is one of the major components of investment decision-making under risk or uncertainty. However, paradoxically, as the 2007–2009 financial crisis revealed, the concept remains misunderstood. Our goal in writing this paper is to correct this issue by reviewing the concept in portfolio theory. The core of our review focuses on the following diversification principles: law of large numbers, correlation, capital asset pricing model and risk contribution or risk parity diversification principles. These four diversification principles are the DNA of the existing portfolio selection rules and asset pricing theories and are instrumental to the understanding of diversification in portfolio theory. We review their definition. We also review their optimality, with respect to expected utility theory, and their usefulness. Finally, we explore their measurement. Keywords Diversification · Portfolio theory · Law of large numbers · Correlation · Capital asset pricing model · Risk contribution · Risk parity · Asset pricing theory · Expected utility theory JEL Classification G1 · G11 · G12
1 Introduction The 2007–2009 financial crisis has raised a large number of questions about the capability of diversification to protect well against loss. Critics (see Fabozzi et al. 2014; Holton 2009, among others) argue that diversification failed to adequately protect against loss during the 2007–2009 financial crisis, because (Pearson) correlations tend to peak during bear markets. For example, Thomas Kieselstein, CIO and man-
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Gilles Boevi Koumou [email protected]; [email protected]
1
Canada Research Chair in Risk Management, Department of Finance, HEC Montréal, 3000, chemin de la Côte-Sainte-Catherine, Montreal, QC H3T 2A7, Canada
2
Department of Economics and Administration Sciences, Université du Québec à Chicoutimi, 555, boulevard de l’Université, Chicoutimi, QC G7H 2B1, Canada
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aging partner at Quoniam, a quantitative asset management firm based in Frankfurt, according to Fabozzi et al. (2014: pp. 28–35), remarks, The financial crisis has clearly shown that when you need diversification most, it may not work. Historical correlations may simply be wrong. Different liquidity of different asset classes may mean that some less risky assets may still be punished because they are tradable. We need better management of such extreme situations. Robert Brown, Ph.D., CFA, with Genworth Financial Asset Management in Encino, California, according to Holton (2009: pp. 21–22), remarks, It doesn’t work and it doesn’t really have much of any connection to the real world...I began to watch it closely starting in the 1980s, and with the passage of each year I’ve appreciated more and more that it’s really nothing more than a marvelous academic concept that has been heavily popularized within the financial planning community. It’s nothing more than an abstraction fro
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