Asset diversification refers to the act of dividing one’s investable capital between different asset classes to manage risk better. It was first coined by Harry Markowitz, one of the world’s most illustrated economists.
For example, we may invest in equities as well as debt instruments for different money goals, diversifying our assets in the process. Asset diversification guides our asset allocation better.
Under the same circumstances, equity and debt instruments usually fare the opposite of each other. The two have a negative correlation so in case of a fall in prices in one there may be an equivalent rise in prices in the other. Asset diversification can help in balancing returns in case of extreme poor performance of one of them.
Markowitz wanted to calculate the portfolio risk and returns quantitatively. According to his theory, the returns on the portfolio will be the average returns on all the asset classes which the portfolio holds, where the risk which is measured in terms of standard deviation of the asset class will be less than the average standard deviation of all asset classes.
Where, σp is the standard deviation of the portfolio or the portfolio risk, W1 is the weight of 1st asset in the portfolio, is the variance of 1st asset in the portfolio,W2 is the weight of 2nd asset in the portfolio, is the variance of 2nd asset in the portfolio, Cov1,2 is the covariance of 1st and 2nd asset in the portfolio.