Diversification (finance) - Return Expectations While Diversifying

Return Expectations While Diversifying

If the prior expectations of the returns on all assets in the portfolio are identical, the expected return on a diversified portfolio will be identical to that on an undiversified portfolio. Ex post, some assets will do better than others; but since one does not know in advance which assets will perform better, this fact cannot be exploited in advance. The ex post return on a diversified portfolio can never exceed that of the top-performing investment, and indeed will always be lower than the highest return (unless all returns are ex post identical). Conversely, the diversified portfolio's return will always be higher than that of the worst-performing investment. So by diversifying, one loses the chance of having invested solely in the single asset that comes out best, but one also avoids having invested solely in the asset that comes out worst. That is the role of diversification: it narrows the range of possible outcomes. Diversification need not either help or hurt expected returns, unless the alternative non-diversified portfolio has a higher expected return.