What is the primary focus of diversification in modern portfolio theory?

The primary focus of diversification in modern portfolio theory is to maximize expected return for a given level of risk. This theory, introduced by Harry Markowitz, emphasizes that investors can construct portfolios to optimize returns by carefully choosing combinations of different assets. By diversifying, investors can reduce the overall risk of the portfolio without necessarily sacrificing expected returns.

The rationale behind this is that different assets often respond differently to economic events; thus, combining assets with low or negative correlations can lead to a more stable overall return. When one asset underperforms, another might perform well, smoothing out potential losses. This balance allows investors to achieve a more favorable risk-return profile compared to investing in single assets or concentrated positions.

In comparison, reducing transaction costs is more about trade execution and operational efficiency rather than the principle of diversification itself. Limiting investments in foreign markets does not align with the goal of diversification, as geographical exposure can add value by tapping into different economic conditions. Concentrating investments in high-performing stocks contradicts the very essence of diversification, as it exposes the investor to higher risk associated with individual stock performance. Therefore, maximizing expected return for a given risk accurately encapsulates the core aim of diversification in modern portfolio theory.