Lesson 1 of 7 · 14 min
The portfolio approach and diversification
Judge every investment by what it adds to the whole portfolio, because combining assets that do not move in lockstep cuts risk far more than it cuts return, although that protection can shrink just when markets crash.
In short
- The portfolio approach evaluates each security by its contribution to the risk and return of the whole portfolio, not in isolation.
- Concentrating wealth in one company (especially your employer) can be ruinous: if it fails, you can lose your job and your savings at the same time.
- Diversification lowers volatility without necessarily lowering expected return: portfolios affect risk more than returns.
- The diversification ratio = standard deviation of the equally weighted portfolio ÷ standard deviation of a randomly chosen single security. Lower means more risk reduction.
- Diversification is risk reduction, not risk elimination and not downside protection: in a severe crisis correlations rise and assets fall together.
- Modern portfolio theory (Markowitz) says the relationships between assets matter; later work (Sharpe, Lintner, Treynor) led to the CAPM, where only systematic (non-diversifiable) risk is priced.
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