Friday, June 15, 2007

Modern Portfolio Theory: what mix of assets should I have?

Many financial advice firms are now fans of Modern Portfolio Theory, which earned Dr Harold Markowitz the Nobel prize in Economics. Explanations can get highly mathematical - the one I've linked to here is a bit more layman-friendly.

But the underlying principle is quite understandable: you can achieve similar investment returns with less risk, by diversifying your assets.

Even within one asset class, such as shares, some items rise and fall together, others move in opposite directions, still others seem to have no particular relationship. If all your shares are in different banking companies, that is still a bet limited to one sector, so it's a relatively risky position in equities.

Risk reduction also means a mix of asset types. A cautious investor may think cash is best, but in effect that is betting on only one horse in the race. Adding some "risky" assets can reduce the risk of the overall portfolio. "Playing safe" is therefore not necessarily the safest way to play it.

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