For this edition of Macro Monday, I decided to discuss a very important component of investing: diversification. I mentioned in an earlier article that diversification is extremely important when it comes to the long-term health of an investors' portfolio. Modern day "Portfolio Theory" was developed by Harry Markowitz - an American economist who received the 1989 John von Neumann Theory Prize and the 1990 Nobel Memorial Prize in Economic Sciences.
Aside from that, Markowitz was the first economist to document through several formulas - that look much more complicated that they are - that a risk-averse investor can construct a stock portfolio to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.
In other words, the more stocks you have in your portfolio with diverse sector exposure, the lower your risk levels. This implies that the return will likely be moderate but positive. He found that there are an optimal number of stocks to minimize risk, yet many other factors (such as duration and share count) also play a role.
You can never completely eliminate risk in a portfolio - just like you can never completely eliminate risk in life.
According to the theory, it's possible to construct an "efficient frontier" of optimal portfolios offering the maximum possible expected return for a given level of risk. This theory was pioneered by Harry Markowitz in his paper "Portfolio Selection," published in 1952 by the Journal of Finance. The “Efficient Frontier” is a modern portfolio theory tool that shows investors the best possible return they can expect from their portfolio, given the level of risk that they’re willing to accept. This is how the theory looks when charted:
For an awesome visualization of this whole concept, watch Investopedia's video by clicking here.
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