Bernd Scherer

Diversification is often called the only free lunch in investing. Yet, what diversification means exactly remains unclear. In this chapter we try to shed more light on the mainstream of so-called diversification-based (often also called risk-based) portfolio construction.


Let us start with a simple question. What is the most diversified portfolio? The literature is not short of candidate portfolios. Equal-weighting, minimum-risk or market-cap-weighted portfolios are only the better-known proposals. In an attempt to overcome this ambiguity and to offer an answer to this nagging question some authors even called their own conjecture the most diversified portfolio. While this was clearly designed to defeat competing diversification ideas, we believe the quest to come up with a better diversified portfolio is ill placed, for three reasons.

First, most attempts to provide better diversification can be seen as special cases of classical mean–variance optimisation. “Special” because we need limited information on the side of the decision maker to reconcile these portfolios with first principles in optimal portfolio construction. Only then does the decision

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