When to Put All Your Eggs in One Basket.....When Diversification Increases Portfolio Risk!

Portfolio diversification may not always lower the portfolio risk, but may actually increase it. It depends on the long memory and distributional stability characteristics of the underlying rates of return. This disturbing result is based on the theoretical Fama- Samuelson proposition of 1965-67. However, there exists now ample empirical evidence for such peculiar results, since most financial return series show long memory, e.g., the S&P500 Index return series. Illiquid real estate and bank loan values are sometimes subject to catastrophic discontinuities. Adding these assets to the portfolio may increase its risk drastically.