The periodic table of the elements is a fundamental concept in chemistry. Just as the chemical elements form the basis for many applications in chemistry, so do asset classes in finance. Understanding the different asset classes that exist in the financial world is key to build a solid, diversified portfolio. In this article I will introduce the concept of the Periodic Table of Investment Returns and its importance for the analysis of diversification.

Diversification is one of the most important rules of investing and sometimes investors believe their allocations are more diversified than they are. In the previous article, I introduced the topic of diversification using the top 10 largest stocks in the S&P 500® Index. Now I will introduce a more formal measure of concentration risk, the effective number of stocks, and examine its historical evolution. In addition, this article will present an index weighting method that is an alternative to market capitalization to reduce concentration risk.

Diversification is the number one rule of portfolio management for many investors. Ray Dalio goes even further calling it the Holy Grail of investing. Colloquially, this is expressed by the idiom “do not put all your eggs in one basket”. In the stock market, this year’s returns in the S&P 500® Index appear to have been concentrated in the stocks with the highest market capitalization. Consequently, these stocks exhibit a higher weight in the index, making it more concentrated, which is contrary to the diversification objective.