We’ve all heard the adage, “Don’t put all your eggs in one basket.” That is the principle of diversification. It turns out to have a great application in investing.
Then a man called Markowitz turned the investing world on its head. He looked at the correlation of returns of different investments. He found that the less correlated investments were to each other the better the long term return of the portfolio. Some investments would go up when others were going down so that losses would be lower.
When analyzing an investment, how it affected the portfolio return became more important than its individual return. Broadly diversified portfolios have better returns over time than undiversified portfolios. This led to a legal standard called the “Prudent Investor.” Good investment advisors will talk to you about diversifying your risks so that you get a better return.
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