Modern Portfolio Theory (MPT) was developed by Harry Markowitz in the 1950s. MPT illustrates the mathematical model behind the concept of diversification. It attempts to maximize the expected return of a portfolio for a given level of risk, by selecting assets whose prices move in opposite directions and weights them such that they meet that optimal tradeoff between risk and return. This process is called asset allocation. The problem however, is that asset allocation does not necessarily equal risk management. One of the main difficulties with MPT, is that by focusing on historical data to calculate asset allocation, it completely ignores extreme risk (2007-2008).

While this is generally accepted as rule of law in the investment business, there is a problem: when done properly, asset allocation can help an investor achieve some level of diversification. However, simply owning several different types of assets does not mean you are protected from major downturns in the markets. This mistaken assumption caused great damage to investors in 2008, when stocks of virtually every size, style and region, suffered tremendous losses. Bonds rescued stocks within many asset allocation plans, and this has led to overconfidence by many investors that bonds will continue to bail them out in the future.

The big difference today, and why we are skeptical that traditional asset allocation will not help manage risk, is that bonds have lost their “cushion.” Their yields are so low that the investor has little more to gain from rushing into bonds as a “safe-haven” investment. That is why in assessing the reward/risk tradeoff of bonds in the investor’s portfolio today, we must focus primarily on the price movement of the bonds. The income portion of bonds’ total returns is just not what it used to be.

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