If you’ve ever walked down the streets of New York or another major city you’ll probably have noticed street vendors selling an array of seemingly unrelated products, from sunglasses to umbrellas and rain ponchos. What, you might wonder, are they thinking? It’s highly unlikely that any customer will buy sunglasses simultaneously as an umbrella or poncho. But that’s exactly the point – the vendors know that when it rains they’ll sell umbrellas, but when it’s sunny the demand will be for sunglasses. They’re simply diversifying their product line to maximize potential revenue, whatever the weather.
The concept of diversification in finance goes back to the 1950s and Harry Markowitz’s seminal work on modern portfolio theory. In simple terms, it means not “putting all your eggs in one basket.” Diversification is intrinsically linked to asset allocation, which is deciding how a portfolio should be distributed among different asset classes. Ever since Markowitz shared his thinking, investors and fund managers everywhere have sought to find the “optimal” portfolio. On this sweet spot, the portfolio’s asset class mix (stocks, bonds, and so on) is such that the investor or fund manager is achieving the highest return for the least amount of risk.
