10 Investment Guidelines: Part 1

 

5. Diversification doesn't depend on the number of asset classes in a portfolio. Rather, it depends on the correlations between the assets classes in the portfolio.

The concept of modern portfolio theory, as made famous by Nobel Laureate Harry Markowitz, states that investors will diversify their portfolios in order to optimize portfolio returns. Key to the theory is the relationship of returns among assets in the portfolio.

In statistical terms, covariance is the way that two random variables change together. In order to maximize diversification, one would seek to include assets or asset classes with low levels of covariance. Adding more assets or asset classes to a portfolio would not necessarily increase diversification and decrease risk. In fact, if the marginal assets have high levels of positive correlation, then you might be taking on more risk and volatility. For example, adding more financial companies to one's portfolio in 2008 would have been detrimental.

Look for Part II of this lesson from Richard Bernstein's farewell research report in the next Finance Professor article.

Scott Rothbort will be on Stockpickr Answers on Monday, June 8, to respond to investing and trading questions posed by members of the Stockpickr community. Not a member? Join the Stockpickr community today -- free.

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At the time of publication, Rothbort had no positions in stocks mentioned, although positions can change at any time.

Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele. He also is the founder and manager of the social networking educational Web site TheFinanceProfessor.com.

Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Term Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.

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