Modern Portfolio Theory (MPT) has been under attack since the great meltdown of 2008. The so-called experts say it no longer works and they point to the financial crisis of 2008 as proof. Well, one thing is for certain and that is that any theory will have a hard time accounting for fraud and greed – two of the culprits of the market meltdown of 2008. We can debate the blame (and probably will) for years to come. In my opinion Modern Portfolio Theory is still valid as is the concept of asset allocation as a means to diversify risk in your retirement portfolio and maximizing your returns.

First, let’s define our terms. What is Modern Portfolio Theory? MPT was introduced in the 1950s by Harry Markowitz who won a Nobel Prize for its discovery. Markowitz stated that you can reduce risk in a portfolio by having different asset classes/investments because each class/investment behaves differently. In other words, some will perform well while at the same time others not so well. As a result you can smooth out the risk (not eliminate it) by having a combination of asset classes i.e. stocks, bonds, real estate, etc.

Asset allocation is the process of selecting the most suitable investments in different asset classes to match your investment goals and risk tolerance. You can review my discussion of risk tolerance by clicking here. Balancing how much of each asset class you should include in your retirement portfolio is one of your most important tasks as an investor. That balance between growth, income, and safety/stability is called your asset allocation. It can help you manage the level and type of risks you face.

Your challenge is to balance the amount of risk you are willing to take against the return that you need on your portfolio to meet your retirement income goals. Let’s say, for example, you need to have a 7.5% return on your portfolio over the next 20 years in order to meet your retirement income goals. You believe that stocks will return an average of 10% and bonds will return 5%. So you might decide that a 50/50 mix of stocks and bonds will get your 7.5% return. That would be your “asset allocation” strategy to put it simply.

As you approach retirement you will typically want to lower the amount of risk that you take since you theoretically have less time to make up for any downturns in your portfolio. Inflation is another factor to consider when selecting investments for your portfolio. Assets like CDs for example typically do not keep pace with inflation so you would not want to put all of your money in CDs if your goal is to beat inflation.

You can even diversify within asset classes. For example, you may decide to invest in growth mutual funds. You could invest within the mutual funds based on industry or even geography either domestically of abroad under the “growth” banner. One of the reasons mutual funds are so popular is because of their “natural diversification”. Think of a mutual fund as a collection of 20 pencils with a rubber band around them. Now try to break that band of 20 pencils. It would be difficult, right? Compare that to taking one of the pencils out of the group of 20 and it would be easy to snap that pencil by itself. That’s the way mutual funds work. The mutual fund manager looks for investments that will complement each other based on the goal of the fund itself.

Once you have selected your asset allocation percentages and then the individual investments within the various asset classes you will need to review and “rebalance” at least once a year. Why? You may have started with a 50/50 allocation between stocks and bonds but a year later it could be 60/40 due to growth in your stock portfolio or losses in your bond. So in order to bring it back into “balance” you would get back to the 50/50 target in our example by selling some of your stocks or buying more bonds to bring it back into balance.

For a more detailed discussion of Asset Allocation please click here.

Time Out! How often do you review your asset allocation in your 401(k) or other investment portfolio? You can leave a comment here.