It is widely accepted that portfolio diversification is one of the most important concepts of modern finance. Based on the Efficient Frontier theory, long-term portfolio performance is not mainly determined by the quality of individual investments, but by the allocation of assets among broad security classes, aiming to target above-average returns with appropriate capital diversification. Successful investing is made immeasurably easier by knowledge of the historical range of returns and risks associated with various security classes. Since the efficient frontier is curved, rather than linear, a key finding of the concept was the benefit of diversification, with the diversified portfolio exceeding the sum of its parts. Thus sub-optimal portfolios, which are typically less diversified, do not comprise the efficient frontier.
Although systematic market risk cannot be diversified away (within one market), diversification can reduce the risk associated with individual assets within a portfolio (the specific- idiosyncratic risk).This asset specific risk within the market portfolio, asset specific risk will be diversified away to the extent possible, given the asset’s volatility and its correlation with the market portfolio.
Modern Portfolio Theory requires knowing the average return and standard deviation of returns for each investment component and also entails knowing how much they move in synchronization with one another . In the famous Mean-Variance model Harry Markowitz and James Tobin demonstrated that risk reduction through portfolio diversification depends on correlations among return distributions of individual securities. Since a security will be purchased only if it improves the risk-expected return characteristics of the market portfolio, the relevant measure of the risk of a security is the risk it adds to the market portfolio, and not its risk in isolation. This fundamental concept of MPT is put under question in the article of Meir Statman and Glenn Klimek ‘‘What measures the benefits of diversification”, where it is claimed that correlation does not serve as an adequate indicator of diversification benefits, and that these benefits do not depend only on the correlation between asset returns.
Arguments in support of this thesis can be found in the article of Natalya (Natasha) Delcoure “Diversification benefits: correlation and return gaps”, where it is claimed that portfolio diversification also depends on the dispersion of asset returns and the concept of return gap is discussed. Specifically, return gaps are associated with standard deviation of an individual asset return around the mean return of all assets, thus representing the gap between the returns of pairs of assets, (whether U.S. and international equity). Return gaps are better measures of the benefits of diversification than correlations because they account for the effects of both correlations and standard deviations and provide a better measure of the benefits of...