I once had the privilege of doing an interview with the Nobel Prize-winning economist William Sharpe at his California home, in which we discussed the finer details of academic finance. But the final question I put to him was a simple one: what is the golden rule of investing?
“There is a rule in real estate,” Sharpe answered, “that the three most important things are location, location, location. My rule in investments is that the three most important things are diversify, diversify, diversify.”
It was, in fact, another Nobel laureate, and a contemporary of Sharpe, Harry Markowitz, who first established the importance of diversification in investing in his famous dissertation Portfolio Selection in 1952.
Until then, financial professionals had assumed that the best investment strategy was simply to choose a selection of securities that were thought to have the best prospects. Markowitz showed that far more important than the individual securities within a portfolio was the portfolio itself, and, specifically, the extent to which the performance of those securities correlated with one another.
“A good portfolio, Markowitz wrote, “is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies.” More memorably, he later described diversification as “the only free lunch” in investing.
This approach to portfolio construction became known as Modern Portfolio Theory. Up to this day, more or less all portfolios have been built, at least to some extent, on MPT.
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