Diversification (finance) - Maximum Diversification

Maximum Diversification

Given the advantages of diversification, many experts recommend maximum diversification, also known as “buying the market portfolio.” Unfortunately, identifying that portfolio is not straightforward. The earliest definition comes from the capital asset pricing model which argues the maximum diversification comes from buying a pro rata share of all available assets. This is the idea underlying index funds.

One objection to that is it means avoiding investments like futures that exist in zero net supply. Another is that the portfolio is determined by what securities come to market, rather than underlying economic value. Finally, buying pro rata shares means that the portfolio overweights any assets that are overvalued, and underweights any assets that are undervalued. This line of argument leads to portfolios that are weighted according to some definition of “economic footprint,” such as total underlying assets or annual cash flow.

“Risk parity” is an alternative idea. This weights assets in inverse proportion to risk, so the portfolio has equal risk in all asset classes. This is justified both on theoretical grounds, and with the pragmatic argument that future risk is much easier to forecast than either future market value or future economic footprint.