Personal Finance Essentials

Modern Portfolio Theory: A Scientific Approach to Investing

Diversifying Across Asset Classes Can

Reduce Risk While Sustaining Return

Investment Markets

The landmark work from Brinson on diversification that preceded the 1986 study was done by Harry Markowitz in the 1950s. He developed Modern Portfolio Theory – a mathematical framework for diversification – and eventually received the Nobel Prize for his work. 

Markowitz showed that diversifying across asset classes can reduce risk while sustaining return. He found that the prices of different assets don’t move together, and by combining various asset classes, you can reduce volatility without sacrificing returns. For example, from 1996 to 2009, a highly diversified portfolio achieved similar returns to an all-stock portfolio but did so with nearly 30% less volatility.

Beyond Markowitz: The Fama-French Model

Decades after Markowitz, Eugene Fama of the University of Chicago and Kenneth French expanded on this work with the Fama-French Three-Factor Model. Their research demonstrated that over long periods: 

Small stocks produce higher returns than large stocks.
Value stocks produce higher returns than growth stocks.
Poorly run companies are often better investments than well-run ones.

This research, along with related work on risk-adjusted returns, forms the academic foundation for modern portfolio construction. Together, these findings reinforce the importance of broad, strategic diversification rather than trying to pick winning investments.