The financial community uses a portfolio modeling theory developed in a 1952 academic paper by Harry Markowitz. For his work on this Modern Portfolio Theory, graphically depicted as the Efficient Frontier, Markowitz won a share of the 1990 Nobel Prize. Despite shortcomings of the model it is used by main-street financial advisors due to its simplicity and availability within software packages.
Diversification is thus a major component of MVO. The Efficient Frontier implicitly calculates correlation by using the portfolio’s co-variances to reduce risk. Diversification is explained by correlations.
Changing the variable correlation from being implicit to explicit gives the investment manager more control and inherently showcases the attributes of investing in diversification enhancing investments like emerging markets and alternative investments.
Diversification Optimization is a model that builds on the geometric analysis introduced by the Efficient Frontier. Just as the optimal portfolio combine to form the Efficient Frontier, the single greatest optimal portfolio rises to form the efficient frame or convex hull of the global optimal allocation model, dominating all others. This is what creates the dominated regions, as the more lengthy vectors dominate the short and unique assets dominate greater regions juxtaposed similarly grouped assets which compete and crowd out one-another for allocation space.
Rather than accepting two variables, risk and return, it incorporates a trans-dimensional factor: diversification. Diversification Optimization assigns each asset a vector by locating each vector in a direction that best explains the correlation with the rest of the assets. The vector lengths are set to a utility function, usually including both risk and return, such as the Sharpe Ratio, Calmar Ratio or Sortino Ratio