"You can divide the history of investing in the United States into two periods: before and after 1952. That was the year that an economics student at the University of Chicago named Harry Markowitz published his doctoral thesis. His work was the beginning of what is now known as Modern Portfolio Theory. How important was Markowitz's paper? He received a Nobel Prize in economics in 1990 because of his research and its long-lasting effect on how investors approach investing today.
Markowitz starts out with the assumption that all investors would like to avoid risk whenever possible. He defines risk as a standard deviation of expected returns.
Rather than look at risk on an individual security level, Markowitz proposes that you measure the risk of an entire portfolio. When considering a security for your portfolio, don't base your decision on the amount of risk that carries with it. Instead, consider how that security contributes to the overall risk of your portfolio.
Markowitz then considers how all the investments in a portfolio can be expected to move together in price under the same circumstances. This is called "correlation," and it measures how much you can expect different securities or asset classes to change in price relative to each other.
For instance, high fuel prices might be good for oil companies, but bad for airlines who need to buy the fuel. As a result, you might expect that the stocks of companies in these two industries would often move in opposite directions. These two industries have a negative (or low) correlation. You'll get better diversification in your portfolio if you own one airline and one oil company, rather than two oil companies.
When you put all this together, it's entirely possible to build a portfolio that has much higher average return than the level of risk it contains. So when you build a diversified portfolio and spread out your investments by asset class, you're really just managing risk and return."
In a paper by Ed Easterling at Crestmont Research, he notes,
"Over the past several decades, the financial community has also realized that the theories of market efficiency, an important assumption for MPT and CAPM, may not be as strict as originally hypothesized. Financial markets are an efficiency process, rather than an efficient condition. In other words, markets function to find the right prices over time, but don’t always reflect all of the information all of the time..."
"...diversification in a portfolio applies to risks, not securities. Other than not being familiar with the investment alternatives, what other rational reason would explain why investors concentrate their portfolios into two major risks when so many options are available?"
So, since MPT diversification applies to risk and not securities, it is possible that concentrated investment portfolios, in and of themselves, may not be a poor investment decision. On the other hand, today, the volatility of the markets is greater than what has been experienced in the past. This greater volatility is compounded in down markets as noted in the chart below.
In conclusion, it is important to remember minimizing risk is really the focus of constructing an investment portfolio. Concentrated investments in individual securities can result in poor returns if their investment characteristics indicate they are more volatile. For example, Black & Decker lost nearly 10% or $8+ in value yesterday. Conversely, utilizing a dividend growth investment discipline to select ones investments may lead to lower downside equity returns; hence, long run outperformance of your investment portfolio.