Retirement Plan Investing
Asset Allocation & Modern Portfolio Theory
One of the most important decisions an investor can make is the appropriate mix of asset classes in their portfolio. Asset classes available generally include stocks, bonds, alternative assets such as commodities, real estate, currencies and cash alternatives. Although there is no one formula for all investors, diversifying your portfolio across multiple asset classes can help boost performance and reduce volatility. This asset class mix will determine the majority of your investment returns.
The framework for asset allocation decisions can be traced to Harry Markowtiz's 1952 article titled "Portfolio Selection". This outline introduces Modern Portfolio Theory (MPT), which shows that risk-averse investors can construct portfolios to optimize expected return based on a given level of market risk, which implies that risk is an inherent part of higher reward, or returns. For example, a more aggressive investor will have a higher relative weighting towards equities over fixed income than a conservative investor.
This overweight to equities will increase the volatility of the portfolio, but the higher returns that have historically been offered by equities will increase the return of the portfolio to a level that compensates the aggressive investor for the extra risk taken. An extension of MPT is the efficient frontier, which shows optimal portfolios that have the highest expected return possible for the given level of risk plotted along a curve. A rational investor would select the optimal portfolio based on their risk tolerance.
The reason a diversified portfolio can increase returns and reduce risk is the idea of correlation, or the lack thereof. Correlation is a statistical measure of how two securities move in relation to each other. If two securities or asset classes have positive correlation, they move in the same direction at the same time. If they have negative correlation, they move in opposite directions at the same time. In theory, a combination of securities or asset classes that are not positively correlated will help reduce the volatility of a portfolio because as one security falls, the other will move in the opposite direction and help alleviate some of the loss.