Modern Portfolio Theory

What is it?  How modern is it?  In summary, it is a diversification within a portfolio that enables the investments to create an upward bias, and limit downward moves.  OK, what is it really?

Let’s start with an example: a young couple are both gainfully employed in a stable company.  The pair would like to take an entrepreneurial leap and open that widget company they’ve dreamed about.  (If both were to do so, they could possibly hamper their ability to, without fail, pay the rent).  Since the couple realizes the risk in both going into an entrepreneur’s role at that time, the decision is made to have half of the couple remain in the salaried position, while the other can jump into the new company effort.  The steady income from the stable salary might be compared to the fixed income (bonds) portion in an investment portfolio.  The new company?  More like the stock portion with the acceptance of some volatility.

In its simplest form, that is modern portfolio theory; somewhat counter-valing forces, aiding the overall picture over time, long and short.  Of course, there is more and, the number of sectors and how they interact (or not) is not to be trivialized.

How does this effect us?  First, to have all of your eggs in one basket may not be clever, especially a stock market basket.  In light of the last decade’s volatility, to disrespect the potential disruption of your investments is wrong.

 

About L N Himel

Site creator and author has well over 30 years experience in the world of Finance at both the institutional and personal levels. As is often true, his successes, but also the pain of the author's mistakes, have resulted in insights that you, the reader, might find helpful in your efforts to avoid pitfalls and poor results. Associated with Himel Financial Services, at http://www.himelfinancial.com/#intro
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