We have all been taught about the merits of diversification in investments. It is a variation of the old adage, "Don't put all your eggs in one basket."

Indeed, professional investment managers are trained to develop portfolios according to the tenets of Modern Portfolio Theory (MPT). MPT traces its roots to the work of Harry Markowitz and his seminal writings on "Portfolio Selection." In his pioneering research, Markowitz was able to demonstrate the mathematical basis for diversification.

Examination

Essentially, Markowitz showed that selecting assets that have a positive expected return but exhibit low or (preferably) negative correlation to one another produces a combined portfolio that retains the positive expected return properties, but with lowered risk (as defined by variance).

Theoretically, this result arises due to the presence of at least two major sources of risk: nonsystematic (or unique) risk and systematic (or market) risk. While it is very difficult to eliminate market risk, it is possible to reduce the risks associated with unique investment assets. By combining investment assets that are subject to certain specific, unique risks with other investment assets that are subject to other unique risks, it may be possible to reduce the overall risk of the combined portfolio.

For the past several decades, this has been the mantra to which all investment managers adhered. Unfortunately, recent experiences in the capital markets have led both academics and professional investment practitioners to rethink portfolio construction. With the increasing interconnectedness of global markets and investment pools, we have seen that correlation structures among various investment assets are not always stable.

In fact, assets that typically exhibit low correlation with one another can dramatically change direction and begin exhibiting increased correlation during periods of market distress. The increased correlation leads to a reduction in the power of diversification and thus to increased risk in the overall portfolio. Unfortunately, this upward shift in correlation happens at exactly the time when an investor needs correlation the most: market distress.

Conclusion

The best portfolio construction techniques have an appreciation for the fact that correlation structures may change during different "states of the world" or regimes. By incorporating these state-dependent correlation structures into portfolio design and optimization, investment managers can move to better protect portfolios during times of market distress.

Disclosures and References

About The Author:

Sharath M. Sury - Founder and Executive Director of the Sury Initiative for Financial Innovation & Risk Management (SIFIRM) at Santa Clara University, Sharath Sury devotes his time and energy to bringing together thought leaders who can address the development of real-world solutions to the current economic climate. Sharath Sury has worked with some of the brightest and most experienced experts in finance and risk management and aims to bring a greater sense of ethics and responsibility to his profession. Through his efforts, Professor Sury has established this invaluable forum for the research and discussion of new developments in the world of economics and finance and has attracted a renewed spirit of innovation to the industry. Sharath Sury also serves as an Adjunct Professor of Economics at the University of California and Adjunct Professor of Finance at DePaul University in Chicago. Sharath Sury's interest and experience in wealth management began as an Associate and later Vice President at Goldman, Sachs & Co. He later founded and worked at S4 Capital, where he earned numerous accolades for his work.

Article Source: http://EzineArticles.com/?expert=Sharath_Sury

Comment on this Focus Brief

Manda Sury

Posted on March 22, 2010

Recommended by:
Chandler Harnish

Sharath Sury makes a good point about the need for "proper" diversification. Just like the multiple "meal groups" required for p[roer nutrition, the health of a portfolio depends on the mix of different asset classes to provide the "rich flavor" for the returns on the portfolio.

One area I would have preferred to see emphasized int he article by SHarath Sury is the role of the investor. Just as each person may have a preferred cuisine, each investor has the taste for certain flavor of risk. Some investors prefer to have very small fluctuations in the returns month-in and month-out -- even if it means that they forego huge positive swigns. They are like the proverbial "tortoise" wining it by being slow and steady. There are other investors who prefer the larger swings- both positive and neagtive -- as long as in the end the postives outweigh the negatives. This type of risk is what Sharath Sury refers to as skew. Finally, kurtosis is the where the investor is willing to wait out for large profits - even if fewer and far in between - as long as the risk of very heavy losses are relatively fewer.

All in all, great article and thought provoking

--- Dr. M. Sury

Chandler Harnish

Financial Consultant

Posted on April 4, 2010

Professor Sury, Great article! I did have one question for you: If you had to choose just three types of assets that should be in a well-diversified, long-term investment portfolio, what would they be?