| The term diversification is used so often in marketing investment products that it’s easy to take for granted. Yet it is crucial to investment success and diversifying a portfolio correctly is not so simple.
The accompanying bar chart analyzes segments of the U.S. stock market by divvying up U.S. publicly-held companies based on valuation and market capitalization. Look at how small- and mid-cap companies dramatically outran returns large-cap companies represented by the Standard and Poor’s 500 Growth and S&P 500 Value Index. This chart covers the five-year period that ended June 30, 2013, but such differences in performance among different segments of the market are not uncommon. In some five-year periods, large-cap growth companies outperform while small-cap companies or mid-caps might outperform in other five-year periods.
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Because no one can reliably predict which market segment will outperform another, it’s wise to avoid making bets on a single segment of the stock market. Put another way, it’s wise to diversify. But what exactly does that mean? Diversification of investments is widely defined as not putting all your eggs in one basket. The egg analogy is something anyone can understand. But diversifying is not as simple as buying a lot of different investments.
To diversify investments, it’s prudent to apply the statistical analysis prescribed in the Nobel-prize winning academic work that forms the basis of Modern Portfolio Theory, or MPT. Modern Portfolio Theory Statistics are based on the Capital Asset Pricing Model (CAPM) of expected returns, which Nobel laureate William Sharpe is credited with developing in the early 1960s. CAP-M (pronounced CAP –EM) was based on the modern portfolio theory first written about in the 1950s by Sharpe’s one-time professor, Harry Markowitz. Markowitz and Sharpe shared the Alfred Nobel Memorial Prize in Economic Sciences in 1990 for their work on MPT. MPT provides a method for analyzing market trends based on measurable characteristics in portfolios, such as standard deviation, which measures volatility, and R-squared, which measures correlation of one market segment to another.
By applying Modern Portfolio Theory, you are able to rebalance and manage your wealth using an organized system of statistical analysis. You are able to measure correlation coefficients to understand how adding an investment to your portfolio has affected a portfolio like yours in the past. You are able to model the future and how your portfolio might behave through different financial and economic cycles. |