Portfolio Theory 101

2008 February 10
by Kyle Bumpus
from → Asset Allocation

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.


Optimize your portfolio with Morningstar’s free Portfolio X-Ray tool (requires free membership registration)


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:

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.

Morningstar Stock Fund Investment Research

Share and Enjoy

Did you enjoy this article?

Please subscribe to our blog via RSS Feed and get great new content delivered straight to your desktop every day!

Or if you prefer, you can have daily updates delivered to you via Email.

2 Responses
  1. 2009 September 8
    Bill permalink

    Hi there, enjoy reading your site. I saw the simple ‘lazy’ portfolio recommended above. I am tyring to put together a lazy portfolio myself and I am thoroughly confused how to do the US equity part, because there are so many lazy portfolios in the media. How so you say “Okay, I’ll take this one”. Its not like they look good or anything. There has to be some logic right ?

    Let us take the above (Bernstein) : 25% in each of 4 funds. ? You split the US domestic equity equally among LargeCap and SmallCap. Why ? Many well known people say that you should go with the Total Stock Market (TSM) as the core because that is basically the market or else you will get “tracking error”.

    But then again TSM has only 10% small cap, so one wonders if they wont get diversification benefit. But then thats the market.

    Is Bernstein doing what is known as “small value tilt” where people load up on small-cap/value stocks with the belief(hope) that it will outperform other asset classes over very long periods as it has done in the past ?

    is this voodoo ? Basically every advisor comes up with his own way of slicing and dicing the market. People say : “Do it as per your taste. Take TSM and add Small Value to taste”. What is “taste”. It is not like Salt/Pepper. It all seems very random to me.

    One answer could be : It doesnt matter. Then why provide so many funds ? Just to confuse people ? I am literally losing sleep over this because I dont like confusion, and dont want to change my AA every year (which is sure to give poor returns). I want something and stock to it, but I just cant make up my mind.

  2. 2010 February 21
    Ethan permalink

    Bill, I realize I’m two years late but the way you framed the question intrigued me. You’re right: there’s plenty of intelligent talk about why passive indexing among diversified asset classes is the way to go, and it’s utterly convincing. But conclusions about what the diversification should look like are hard to come by. Here are some conclusions I have established to date in my own mind:

    1. Correlation, expected returns and standard deviation are the key attributes of an asset class; not its name, market cap or how other people have decided to treat it.

    2. The percentage of the market represented by an asset class really doesn’t matter. So US large cap is 40% of the global equity market. Who cares? What bearing does that have on your risk and return? Zero. Starting your allocation with market cap and moving from there is no better than throwing darts to determine a starting allocation.

    3. Start with your fixed-income vs. equity (or equity-like) decision. That may be a slightly artificial or fuzzy division, but not harmfully so. This breaks your decision down into slightly more constrained chunks.

    4. Next make your domestic vs. international decision for both sides of your portfolio. Again, this constrains your future decisions a little bit, making them simpler. Start with a 50/50 assumption and move it only if you can identify a positive reason to do so. (There may be, such as currency risk concerns. But make yourself identify them before you budge. Currency risk has a diversification benefit, so it comes down to your personal situation and goals.) Why start at 50/50? If you have two assets that have identical returns but aren’t perfectly correlated, and that is all that you know, then the mathematical answer is that 50/50 is the best decision. It will reduce the combined standard deviation by the greatest amount. So start there and make yourself find reasons to move.

    5. Since you have to start somewhere on actual asset classes, start with the assumption that within each side of your portfolio (fixed income / equity) you will allocate equal portions to whatever asset classes you choose. Same reasons as above. Then depart from that only when you have a positive reason to do so.

    6. Get a feel for the total number of asset classes you feel good about using. It’s commonly said that more than 12 provides diminishing returns. I would think that anyone as interested as you would want at least 4, and I accept the standard advice and cap myself at 12. Let’s pick 10 for our example – it’s obviously flexible, but it gives you a place to start. Remember that your portfolio size can limit you here. If you only have $10k, start with 3 or 4, be patient, and complicate it later when you have $25k or more.

    For example, let’s say you chose 70% equity and 30% fixed-income. Then you chose 60/40 domestic/international for the equity side (perhaps because you think that doing poorly while the US is doing well would pressure you to abandon a 50/50 allocation) and for simplicity’s sake you are happy with 100% domestic for fixed income. Now set that aside and examine the available asset classes for correlation, expected returns and standard deviation. Of course you are trying to maximize three variables here, so there is a whole set of right answers. There is no “best”. Make sure that your average expected return is enough to meet your goals, that your combined standard deviation is within your risk tolerance, and that correlation is low enough to take a good stab at lowering combined standard deviation in practice. Don’t allow the low correlation focus to get lost in the shuffle, here. That’s the free lunch. Don’t miss the free lunch!

    So now you’re down to questions like: “30% of my portfolio will be international equity. I don’t want to exceed 10 total asset classes and I want to diversify each portion of my portfolio, so I have 3 asset classes to choose in this part. What three asset classes should make up my international equity component?” That finally starts to look like an answerable question!

    There are still choices to be made, but you can review what you’ve read about each option and pick three that fit your overall goal. Remember, there are multiple right answers. How about 10% Europe Index, 10% Pacific Index, and 10% Small Value Index? If you would like to add an Emerging Markets Index, not to skew risk/return too far but for the low correlation, that might be a good reason to break the equal allocations: reduce Small Value to 5% and allocate 5% to Emerging Markets. Keep your eyes on the reasons. If you *did* want to increase returns, then the right answer might have been to combine Europe/Pacific into a World Index at 10% and to bring Emerging Markets in at a full 10% itself.

    Rinse and repeat for the other components of your portfolio. If you feel lost within a component, read more about the asset classes that are available to you until you start seeing factors that make sense to base a decision on.

Comments are closed.