Modern Portfolio Theory drives the need for the trustee to diversify thus minimizing the risk to the portfolio. The diversification required by the Modern Portfolio Theory, however, is not merely holding multiple securities. It is constructing a portfolio where the inherent risk of the portfolio is balanced by the various holdings:
A fundamental tenet of MPT is the premise that all investments, including U.S. Treasuries, may become worthless or more commonly, may not perform in the manner anticipated, a concept referred to as “risk.” Every investment faces internal and external factors which give rise to risk, known as “firm risk.” Every company faces the internal risk of being defrauded by an employee or a third party. In addition, factors outside the company, external factors, also impact the value of an investment. For example, during the oil embargo of 1973, international oil stocks decreased in value, but the shares of domestic oil producers increased in value. A portfolio which consisted of both stocks reduced risk because the decline in value of the international oil stocks was offset, in whole or in part, by the increase in value of the domestic oil producers. Of course, both of these oil companies are impacted by demand for oil. To reduce risk, an investor should invest in a wide range of stocks and even in different asset classes that move in different directions as various external market changes occur. In MPT parlance, investors should acquire investments that have negative or low correlations to each other. By purchasing assets with negative or low correlations to each other, an investor can substantially reduce the risk associated with a specific investment. Diversification thus involves much more than buying stocks in two companies versus only holding stock in one company. It involves purchasing stocks, bonds, hedge funds, commodities, and other investments in a manner to reduce the “diversifiable risk” of investing in a single asset or single class of assets. Managing risk thus involves using “care and skill in an effort to minimize or at least reduce diversifiable risks.”
According to MPT, investors demand a higher return for taking on more risk. For example, U.S. Treasuries provide relatively little return because they present little risk. On the other hand, investors demand higher returns from stocks in small companies which have a greater probability of disappointing investors. According to MPT, the market pays investors for taking on more “compensated risk,” that is risk associated with fluctuating interest rates, inflation, exchange rates and general market changes. However, as stated in the comments to UPIA §3, “nobody pays the investor for owning too few stocks.” An investor, therefore, receives no market benefit for retaining a concentration. Since an investor can reduce the risk of holding a concentration by diversifying, yet not decrease return, it is imprudent for an investor to hold a concentration unless non-market factors justify retaining the concentration. Hence, unless special circumstances exist or the trust waives the duty to diversify, the UPIA requires a trustee to diversify because prudence dictates against a fiduciary taking uncompensated risk. “Sound diversification is fundamental to the management of uncompensated risk.” Diversification may be the most universally accepted precept of prudent investing.
The poster child for the case for compelling trustee distribution under the prudent investor rule is In Re Will of Dumont, a case (until reversal) imposed a $21 million surcharge on the corporate trustee. In that case, a testator left his Eastman Kodak stock to a trust with the direction that it be preserved for eventual distribution to his heirs at the termination of the trust. The trust provisions also, however, provided that the stock could be sold if there was “some compelling reason other than diversification of investment” to sell the stock. The Dumont Court held that the Prudent Investor Act makes diversification a default requirement for trusts.
Diversification was recognized as a part of the trustee’s general duty of prudence in a Maryland case pre-dating the adoption of the Prudent Investor Rule. In that case, Green v. Lombard, the Court of Special Appeals upheld a surcharge resulting from losses that would have been minimized if the investments had been more diversified (the trustee “failed to diversify investments so as to minimize the risk of large losses.”). In that case, however, “diversification” is probably not used as it would be under the Modern Portfolio Theory.
 Trent S. Kiziah, The Trustee’s Duty to Diversify: An Examination of the Developing Case Law, 36 ACTEC L.J. 357, 359-61 (2010).
 In Re Will of Dumont, 4 Misc. 3d 1003(A), 791 N.Y.S.2d 868 (2004).
 Green v. Lombard, 28 Md. App. 1, 7, 343 A. 2d 905, 910 (1975).