Modern Portfolio Theory 2.0 - The Most Diversified Portfolio

Nov. 28, 2012 2:50 PM ETAGG, GLD, LQD, TIP, TLT, VGK, VNQ, VTI, VWO88 Comments
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In recent years, new portfolio construction techniques focused on risk and diversification rather than expected average returns have become quite popular. This success has been due to an increasing acknowledgment that a traditional balanced portfolio, where 60 percent is allocated in equities and the remaining 40 percent is invested in bonds, is not diversified at all. It may look balanced from a capital allocation point of view, but it is not from a risk perspective, as equities are the main risk contributor within such a portfolio. After we have already written about the risk parity approach in our last article, we would like to review a portfolio construction technique, called "Maximum Diversification," which has shown incredible results so far and which is being updated on a regular basis on our website.

The basic idea behind the maximum diversification approach is to construct a portfolio that maximizes the benefits from diversification. First of all, diversification can be measured by the so-called diversification ratio. This ratio is the portfolio's weighted average asset volatility to its actual volatility. The result of this calculation measures the essence of diversification. Since different asset classes are not perfectly correlated to each other, this ratio in general > 1. In other words, a well-diversified portfolio is greater than the sum of its investments, as the overall risk of such a portfolio is less than the weighted-average risk of its component holdings. Therefore, every investor can measure the degree of diversification within its portfolio quite easily, with the following metric:

Formula Diversification Ratio

(wi = portfolio weight in asset i, σi = the risk of asset i, σp is the total risk of the portfolio)

Moreover, for a given set of underlying assets, there is only one portfolio combination that has the highest diversification ratio and thus represents the most diversified portfolio. In other

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