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Diversification and portfolio theory: a review

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  • Gilles Boevi Koumou

    (HEC Montréal
    Université du Québec à Chicoutimi)

Abstract

Diversification is one of the major components of investment decision-making under risk or uncertainty. However, paradoxically, as the 2007–2009 financial crisis revealed, the concept remains misunderstood. Our goal in writing this paper is to correct this issue by reviewing the concept in portfolio theory. The core of our review focuses on the following diversification principles: law of large numbers, correlation, capital asset pricing model and risk contribution or risk parity diversification principles. These four diversification principles are the DNA of the existing portfolio selection rules and asset pricing theories and are instrumental to the understanding of diversification in portfolio theory. We review their definition. We also review their optimality, with respect to expected utility theory, and their usefulness. Finally, we explore their measurement.

Suggested Citation

  • Gilles Boevi Koumou, 2020. "Diversification and portfolio theory: a review," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 34(3), pages 267-312, September.
    • Handle: RePEc:kap:fmktpm:v:34:y:2020:i:3:d:10.1007_s11408-020-00352-6
    DOI: 10.1007/s11408-020-00352-6
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    More about this item

    Keywords

    Diversification; Portfolio theory; Law of large numbers; Correlation; Capital asset pricing model; Risk contribution; Risk parity; Asset pricing theory; Expected utility theory;
    All these keywords.

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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