10 Investment Guidelines: Part 1

5. Diversification doesn't depend on the number of asset classes in a portfolio. Rather, it depends on the correlations between the assets classes in the portfolio.

The concept of modern portfolio theory, as made famous by Nobel Laureate Harry Markowitz, states that investors will diversify their portfolios in order to optimize portfolio returns. Key to the theory is the relationship of returns among assets in the portfolio.

In statistical terms, covariance is the way that two random variables change together. In order to maximize diversification, one would seek to include assets or asset classes with low levels of covariance. Adding more assets or asset classes to a portfolio would not necessarily increase diversification and decrease risk. In fact, if the marginal assets have high levels of positive correlation, then you might be taking on more risk and volatility. For example, adding more financial companies to one's portfolio in 2008 would have been detrimental.

Look for Part II of this lesson from Richard Bernstein's farewell research report in the next Finance Professor article.

Scott Rothbort will be on Stockpickr Answers on Monday, June 8, to respond to investing and trading questions posed by members of the Stockpickr community. Not a member? Join the Stockpickr community today -- free.