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A Modern Approach to Asset Allocation: Part 1

The phrase “Don’t put all your eggs in one basket” is another way of saying that no one should risk all of their resources on any single idea, venture, or asset. Put simply, if all your eggs are in one basket, and the basket breaks or spills, then you’ll lose all your eggs.

It’s especially important to follow that advice in your financial life by diversifying your investments across different types of assets and securities. Ideally, diversification lowers risk in a portfolio while still enabling returns high enough to achieve an investor’s financial goals. For instance, a portfolio consisting of just one stock is far too risky — no matter how strong the bullish argument for that stock may be. A variety of factors could derail the investment, including fraud, deteriorating economic conditions, and increased competition.

At the same time, investors who choose a less “risky” investment class — say, a 30-year U.S. Treasury bond — will probably face other risks. Namely, while these investors face far less danger of losing their principal, they run a very real risk of not achieving returns high enough to reach their goals or even maintain their buying power in the face of inflation.

The importance of asset allocation

The aim of diversification is to avoid each extreme, allowing investors to achieve high returns while reducing volatility along the way and making it unlikely that they will suffer from a permanent loss of capital. The primary means of accomplishing this is through asset allocation, the practice of dividing investment money into different classes of assets — such as stocks, bonds, real estate, and cash — that will act independently of each other. Some more exotic asset classes include cryptocurrencies, gold, fine art, commodities, and much more. These classes can be further divided into several sub-sectors that will be examined more closely below.

Asset allocation is extremely important. Studies show that asset allocation is a larger contributor to a portfolio’s overall returns than even individual stock selection. A 2000 study by economists Roger Ibbotson and Paul Kaplan concluded that more than 90% of a portfolio’s long-term returns were driven by its asset allocation. While this study was meant more for institutional investors and fund managers than for individual investors, it cannot be denied that a portfolio’s asset composition plays a large role in its long-term returns.

What is the modern portfolio theory?

The modern portfolio theory stems from “Portfolio Selection,” a research paper published in 1952 by Harry Markowitz, who was later awarded a Nobel Prize in economics for his important contribution. The key takeaway from Markowitz’s paper is that assets should not be weighed by their risk-reward proposition individually but, rather, by how each asset fits into an overall portfolio. For an over-simplified example, a speculative biotech company’s stock might not be considered too risky for an investor with a suitable time horizon and a basket of other, more conservative investments in their portfolio.

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