Modern Portfolio Theory’s Third Rail: Achieving
Wealth Mobility Through Idiosyncratic Risk

Abstract

The goal of wealth generation demands a different investing strategy than the goal of wealth preservation. This article attempts to understand the impact of portfolio diversification on the ability of an investor to move up the wealth spectrum. While modern portfolio theory systematically eliminates idiosyncratic risk to create an optimal diversified portfolio, the authors’ conclusion is that upward wealth mobility is unlikely without the assumption of idiosyncratic risk. The authors use simple quantitative arguments to demonstrate that if an investment portfolio were limited to well-diversified portfolios lying along the efficient frontier, it would take close to a century to materially change the investor’s relative (wealth) position in society. A variety of data sources, including the Survey of Consumer Finances, the Forbes list of wealthiest individuals, and historical market returns are used to support those conclusions.