Portfolio Theory 101

At its root, portfolio theory is about guarding against uncertainty.  If you knew ahead of time which stocks or asset classes would perform best in any given time period, it would be foolish to diversify.  Unfortunately, crystal balls that accurate are really, really expensive.  Since most of us aren’t privy to such information, we have to make due with using the past as a guide.  Fortunately, we have Modern Portfolio Theory to guide us.

Central to Modern Portfolio Theory is the concept of market efficiency.  Simply put, this implies that consistent stock picking is impossible.  New information is factored into stock prices too quickly for market players to profit from it.  Now whether this is entirely true is outside the scope of this post, but that is the prevailing theory.  The problem becomes this: if stock picking is impossible, how does one profit from the stock market with an acceptable level of risk?  The answer: diversification.

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The idea is to own a broad range of uncorrelated or weakly correlated asset classes.  Coefficients of correlation run from -1 to 1 with -1 being inversely correlated, 0 being uncorrelated, and 1 being perfectly correlated.  A correlation of 0 means that 2 asset classes do not move in lock-step with one another.  Poor performance in one asset class tends to be offset by good performance in another.  In real life, anything with a correlation of less than 0.7 will have significant diversification benefits.  As an example, intermediate-term US Treasury Notes have historically (1979-2004) had a coefficient of correlation of just 0.16 with the S&P 500.  Because of this, having a significant portion of your portfolio in Treasury Notes would have significantly reduced risk without reducing return.  This is because Treasury Notes tended to zig when the S&P 500 zagged.

In the real world, it is very difficult to find two or three mutually uncorrelated asset classes and pretty much impossible to find four.  Fortunately, we don’t need four completely uncorrelated to get the benefits of diversification.  Some historically weakly-correlated asset classes you might want for your portfolio are US large-cap stocks, US small-cap value stocks, foreign large-cap stocks, foreign small-cap stocks, short-term US bonds, short-term foreign bonds, real estate, and commodities.  If this seems too complicated, you can achieve most of the benefits of diversification (probably 90+%) by simply owning equal portions of the following four asset classes in your portfolio:

• 25% US Large Cap stocks (Vanguard 500 Index Fund)
• 25% US Small Cap stocks (Vanguard Small-Cap Index fund)
• 25% Foreign Large Cap Stocks (Vanguard FTSE All-World ex US Index Fund)
• 25% US Short Term Bonds (Vanguard Short Term Bond Index Fund)

With just these four funds, you will likely outperform the vast majority of professional money managers with a moderate level of risk.  What’s more, it will probably take you less than 30 minutes per year to manage this simple and effective portfolio.

The final step in managing your portfolio is rebalancing.  Since over time different asset classes will tend to behave differently, your portfolio will eventually drift away from its original asset allocation.  For example, if US small-cap stocks have a big year while bonds and foreign stocks do poorly, you will end up with a portfolio heavy in small-cap stocks and light in the other asset classes.  By rebalancing, you move money from your winners (small-cap stocks) to your loser (foreign stocks and bonds).  Rebalancing is simply a mechanical method of buying low and selling high.   If you don’t rebalance your portfolio, you may find that after a few years you are both less diversified and taking on far more risk than you originally intended.  Rebalancing once every year or so will ensure that your portfolio stays allocated like you originally intended.