Markowitz’s Modern Portfolio Theory, first published in a paper in 1952, showed how uncorrelated assets complement each other, lowering risk while at the same time increasing expected returns.
In the most basic sense, diversification is achieved by investing in different asset classes that are expected to have low correlation with one another – equities, bonds, real estate, and cash.
What drives that low correlation is the different primary risk that each asset class is exposed to. Investors are compensated with a “risk premium” over a reference rate – the so-called risk-free rate – for putting their money in a specific asset. For example, high yield bonds are exposed to a risk of default (a credit risk premium), government bonds to surprises in inflation or a government default (term premium), and equites to market risk (equity risk premium).
When equity markets are underperforming, assets like cash and fixed income can compensate for some of those losses and buoy the overall return of a portfolio.
Rarely, but not never, do all these different risks occur at the same time.
