DIVERSIFICATION: RECENT LEGAL AND ACADEMIC PERSPECTIVES
By Patrick J. Collins, Ph.D., CLU, CFA*
I. INTRODUCTION: A SEMINAL ARTICLE IN THE HISTORY OF MODERN PORTFOLIO THEORY
James Lorie (co-founder of the Center for Research in Security Prices at the University of Chicago) published, in 1975, an important article on portfolio diversification.1 Investors, in Lorie’s opinion, fail to appreciate certain critical implications of academic research with respect to construction of investment portfolios. Specifically, Lorie states that merely picking "good" or "safe" stocks cannot reduce risk. Portfolio construction is not optimal when it merely bundles together stocks of blue chip companies (firms exhibiting strong current financial statements and favorable accounting ratios). Rather, portfolio risk reduction depends on combining securities with differing economic characteristics as measured by their volatility and tendency to move either in tandem or separately from each other. Investors who seek only to maximize returns (i.e., those who do not care about risk) will put all of their money in the single most promising security (or sector). Investors who are concerned about risk, however, will employ a strategy of diversification.
Lorie points out that modern portfolio theory views risk as being composed of two elements. The first source of risk ("risk" is defined as uncertainty about the magnitude and direction of future price changes) is "market risk." Market risk includes changes in rates of industrial production, inflation, national income, unemployment, tax rates, regulatory policies and so forth. This risk cannot be eliminated through diversification simply because it exists as part of the marketplace itself. The only way to avoid market risk is to avoid the market – i.e., not investing. The second source of risk is "idiosyncratic" or "firm-related" risk. This is the risk that affects individual companies. It includes poor decision making by management, technological obsolescence, litigation risks, strikes and labor unrest, and so forth. Examples of firm-related risk include the placement of arsenic in Tylenol manufactured by Johnson & Johnson, the crash of the corporate jet carrying the top management of Texas Gulf Sulphur, the reactor failure of the General Public Utilities facility at Three Mile Island, and Enron’s stealth accounting procedures. Scientific diversification aims at reducing idiosyncratic risk. One of the central tenets of modern portfolio theory is that idiosyncratic risk is uncompensated risk – because idiosyncratic risk can be eliminated, the market does not reward those who voluntarily elect to assume it.