Diversification and portfolio theory: a review

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.

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Notes

  1. 1.

    http://juchre.org/talmud/babametzia/babametzia.htm.

  2. 2.

    http://juchre.org/talmud/babametzia/babametzia.htm.

  3. 3.

    See http://www.tobam.fr/about-us/ for more details.

  4. 4.

    For more details see https://www.onefpa.org/business-success/ResearchandPracticeInstitute/Pages/2018TrendsInInvesting.aspx.

  5. 5.

    http://www.ai-cio.com/2016-Risk-Parity-Investment-Survey/.

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Acknowledgements

This paper is based on material from the author’s dissertation in the Department of Economics at Université Laval. We gratefully acknowledge the financial support from FQRSC (Fonds de Recherche de Québec-Société et Culture) [grant numbers 176559], and Canada Research Chair in Risk Management. We also thank the anonymous referee for helpful comments.

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Correspondence to Gilles Boevi Koumou.

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Koumou, G.B. Diversification and portfolio theory: a review. Financ Mark Portf Manag (2020). https://doi.org/10.1007/s11408-020-00352-6

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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