Diversification and portfolio theory: a review

Diversification is one of the major components of investment decision-making under risk or uncertainty. However, paradoxically, as the 2007–2009 financial crisis revealed, the concept remains misunderstood. Our goal in writing this paper is to correct this issue by reviewing the concept in portfolio theory. The core of our review focuses on the following diversification principles: law of large numbers, correlation, capital asset pricing model and risk contribution or risk parity diversification principles. These four diversification principles are the DNA of the existing portfolio selection rules and asset pricing theories and are instrumental to the understanding of diversification in portfolio theory. We review their definition. We also review their optimality, with respect to expected utility theory, and their usefulness. Finally, we explore their measurement.