Diversification and an "Efficient" Portfolio

According to Modern Portfolio Theory, you can limit the volatility of your portfolio by spreading your risk across different types of investments. In fact, by putting together a basket of risky or volatile stocks, the overall risk of the portfolio would actually be less than any one of the individual stocks in it.

Diversification depends more on how the securities perform relative to one another than on the number of securities a you own, though. Markowitz compared a portfolio of 60 railway securities with another portfolio of the same size that included railroads, utilities, mining, and manufacturing companies. He concluded that the latter is better diversified. 'The reason is that it is generally more likely for firms within the same industry to do poorly at the same time than for firms in dissimilar industries,' he says.

The 'right' kind of diversification requires investors to own securities that don't behave alike. In other words, their price movements have low correlation with each other.

Correlation measures the degree at which two securities move in similar patterns. Correlation value ranges from -1.0, indicating two securities moving perfectly opposite each other, to 1.0, indicating two securities moving in tandem. So to spread out risk, clients would want the securities in their portfolios to have correlations closer to -1.0 than to 1.0.

According to Markowitz, the goal is to craft an 'efficient' portfolio. An efficient portfolio is either a portfolio that offers the highest expected return for a given level of risk, or one with the lowest level of risk for a given expected return. The line that connects all these efficient portfolios is the efficient frontier. The efficient frontier represents that set of portfolios that has the maximum rate of return for every given level of risk. The last thing that investors want is a portfolio with a low expected return and a high level of risk.

No point on the efficient frontier is any better than any other point. You'll need to examine your own risk and return preferences to determine where to invest on the efficient frontier. Each of the target models offered in Scottrade Portfolio Review Tool is plotted on an efficient frontier on the second page of the Target Model Comparison (PDF). When you create a portfolio using one of the target model frameworks, you're adopting the risk and return characteristics of the target model you select. Make sure to fully research the return objectives and risk expectations of each model before you make any changes to your portfolio.

Read Next: Applying Modern Portfolio Theory to Your Investment Reality

Keep in mind that while diversification may help spread risk it does not assure a profit or protect against loss in a down market.

The analytical tools described in this article are for information purposes only and their use does not guarantee a profit. None of the information provided should be considered a recommendation or solicitation to invest in, or liquidate, a particular security or type of security. Investors should fully research any security before making an investment decision.