The Wrong Kind of Diversification

Individuals managing their own assets receive no legal guidance on the standards for prudent investing.Fortunately, they can look to the Uniform Prudent Investor Act for guidelines. The act sets forth standards that govern the investment activities of trustees, and is currently the law in almost every state. While those standards do not apply to individuals managing their own assets, they do provide guidance on what the courts consider prudent investing.

Modern Portfolio Theory identifies asset allocation as the most important issue when investing and managing assets, because it determines well over 90 percent of the risk and expected reward of a portfolio. In fact, the act identifies the tradeoff between risk and return as the fiduciary's central consideration. The act incorporated one of the most important tenets of MPT in stating, "Because broad diversification is fundamental to the concept of risk management, it is incorporated into the definition of prudent investing."