Modern Portfolio Theory: How many rooms do you need in your house?

Your strategy's in place. Now it's time to look to the next step -- what types of products will help you implement your strategy. In other words, now you need a portfolio. And don't look at prospectuses or annual reports yet! You're still not ready to buy products.

A portfolio isn't just a collection of products, no more than a house is just a collection of rooms. If you own a bunch of products without having a portfolio, you may have a house with two dining rooms, four livings rooms and no bathrooms or kitchen. Having a portfolio is like saying, "I need a house with four bedrooms, one big kitchen, three baths, a living room and a family room, and here's how big I'd like them to be." Now you've got a functional house - a house that meets your specific needs.

What you've done is allocated space, just what a portfolio does. A portfolio is your allocation of investment space. Instead of doing it by rooms or square footage, we do it by percentages of your resources: 10% in this type of asset, 40% in that, 15% in another.

Modern Portfolio Theory, whose originators won the 1990 Nobel Prize in Economics, champions the notion that the particular asset class that one is invested in accounts for the vast majority - over 90% - of the portfolio's performance. (This finding, based upon a 1986 research report* on 91 large pension funds by a prestigious pension fund consulting firm, concluded that the two remaining primary investment strategies -- market timing and stock selection - had minimal effects on performance.) This led Dr. Markowitz, one of the 3 Nobel Prize recipients, to argue that for every level of risk, there is some optimum combination of asset classes, known as the "Efficient Frontier", that will provide the highest rate of return for a given level of risk assumed. Although there are no guarantees in investing, it is on this philosophy that we base our asset management decisions and recommendations. When planning your life, your future, you have to think of risk and return in the broadest terms. Risk may not mean losing money, rather it may mean losing opportunities - in financial or personal terms. Reward may be more than making money, it may mean increasing financial security or enhancing your enjoyment of life. 1

1 The Prudent Investor's Guide to Beating the Market, Reinhardt, Werba, & Bowen, Irwin Professional Publishing, Chicago, Pgs, 5-23. *Based on a 1986 study, more recent studies may reflect different results.

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