For many years “alpha” – outperformance of the market on a risk-adjusted basis – was the Holy Grail of investment. Almost all money managers claimed they could produce it. Then, under the weight of an Everest-high mountain of evidence that no investment manager – not mutual funds, not hedge funds – could reliably produce alpha, at long last, a significant minority of investment managers have stopped laying claims to it. For many of these there is now a new Holy Grail: diversification. But there is little agreement as to what it means.

“‘When I use a word,’ Humpty Dumpty said, in rather a scornful tone, ‘it means just what I choose it to mean – neither more nor less.’ “The question is,” said Alice, ‘whether you can make words mean so many different things.’ ‘The question is,’ said Humpty Dumpty, ‘which is to be master – that’s all.’ ” [1]

To try to understand what the new advocates of diversification mean by their versions of it, let’s dissect diversification, first focusing on what most of them agree on. Then we’ll go on to consider the cacophony of new claims – no longer to “alpha,” but to “diversification.”

The only free lunch in investing

The phrase above, applying to diversification, is often attributed to Harry Markowitz’s 1952 paper, “Portfolio Selection” – but it isn’t actually there. Whoever did originate this phrase, there is truth to it. If it is expected volatility that takes away your lunch, and expected return that gives it to you, then combining two assets or securities with the same return and less than perfect correlation reduces your expected volatility without reducing expected return; a free lunch – at least if you are risk-averse.

That’s two assets or securities. What if you add more? It keeps on giving you a free lunch – up to a point. What that point is, and how to find it, are the subject of a long chain of theorizing.

Markowitz traveled that route a good part of the way. I find it amazing that his paper has been the touchstone of investment theory and has been discussed extensively for 65 years, yet the man himself is still younger than my spry 90-year-old uncle. Markowitz’s construction is well known, and can be portrayed as in Figure 1.

Figure 1. Efficient frontier

Diversified Portfolios

Diversified Portfolios

By Michael Edesess, read the full article here.