Even though this viewpoint seems to place me squarely in the market efficiency camp, I would like to add two important caveats. The first concerns investing in the presence of asset price bubbles. The second concerns the best investment policy for investors who are forced to hold under-diversified portfolios.

In the face of a stock market bubble like the technology bubble in the late 1990s, some efficient-markets proponents would argue that investors should not alter their investment strategies one bit. After all, even if prices appear too high to explain, other investors are also aware of this. Expected returns are still positive because otherwise investors would sell. There is no telling when the bubble will burst. On the other hand, a second cornerstone of financial theory is that stock prices (like the prices of all financial assets) are ultimately tied to fundamentals, that is, to cash flows. If prices are many times higher than any reasonable expectation of future cash flow can justify, this suggests investors are taking a much greater risk than in normal times. Investing in a bubble is a bet that someone will come along and buy a share of stock from you at a price that is even further out of line with fundamentals than the one you paid. This cannot continue indefinitely; the resources of the real economy ultimately limit the value of the market. Eventually market participants must come to their senses and prices must return to earth. It is reasonable, then, for investors with a limited taste for risk to sit out bubbles, shifting their money to less speculative investments. (Readers interested in further exploring this viewpoint are directed to the writings of Professor Robert Shiller of Yale University.)

For many investors diversifying is simple. It involves investing in a broad-based stock index fund and other asset classes, such as real estate and bonds, with the portion devoted to each asset class reflecting an individual’s taste for risk. For some investors, such as top executives and owners of small businesses, the optimal diversification strategy is not so straightforward. In the last few years my colleague, John Heaton at the University of Chicago, and I have been studying the question: Is standard portfolio theory an appropriate prescription for investors who are forced to invest heavily in their own companies? Typically, corporate executives receive company stock and stock options as part of their compensation package. This provides an added incentive for managers to act in the interest of shareholders. Small business owners similarly hold a substantial portion of their wealth in their own companies. A cost of this practice is that entrepreneurs and managers are exposed to considerable risk with few outlets for diversification.

If you have no choice but to invest heavily in your own company, as is the case for many wealthy people and even some workers, placing your unrestricted savings in the market portfolio is unlikely to maximize the benefits of diversification. There is the potential of further reducing your risk by judiciously choosing investments that will tend to perform well when your company is faltering. This is consistent with the basic logic of diversification that certain risks tend to be offsetting.

Consider an executive at General Motors who is heavily exposed to GM risk. Not only does her job depend on the fortunes of GM, but she also holds a large portion of wealth in GM stock and options. If she also invests her unrestricted savings in a diversified stock portfolio, it will include the stocks of Ford, GM, Chrysler, and other car companies. This increases her overexposure to auto industry risk. A well-structured diversifying portfolio would avoid investments in the auto industry or might even involve taking a short (i.e., negative) position in the stock of other automobile manufacturers. Similar considerations apply to employees forced to hold retirement savings in the form of own-company stock. Those workers not only face the undiversified risk of losing their jobs, but they also risk simultaneously losing their retirement savings. A sad but not uncommon example is the case of Enron, where employees find themselves with no jobs and little or no savings. Diversification for workers means holding their savings in portfolios that avoid own-company stock.

These examples lead to the conclusion that many people could further reduce their risk exposure by thinking about what diversification means in their personal situations. Taking this approach, one would generally start with a diversified market portfolio and then add or subtract particular stocks so as to hedge the risks from restricted stock holdings or job loss. While sophisticated investment managers already employ such strategies on behalf of high-end clients, I am optimistic that a broader awareness of this issue will eventually be used to help a much broader