Asset Allocation and Its Role in Modern Portofolio Theory

What does MPT tell an investor about how to choose the components of a portfolio? The first idea is to diversify one’s holdings and to allocate part of the investment capital among several asset classes. Reasonably enough, this strategy is known as asset allocation. Not so many years ago, asset allocation meant owning a variety of stocks and bonds and some cash equivalents.

The prudent man rule reinforced this type of thinking among fiduciaries, or those responsible for investing other people’s money.Today MPT goes further and focuses on the portfolio as a whole, and not on its individual components. But proper diversification remains an essential ingredient of MPT.

When following MPT to build a portfolio, it’s not sufficient to compile a portfolio simply by investing in different asset classes (e.g., stocks, bonds, gold, and real estate). MPT teaches that it’s important to find the optimal allocation of assets satisfying both the investor’s risk tolerance and reward (expected rate of return). It’s important to own a variety of investments that perform differently in the marketplace. In other words, there should be minimal correlation in the performance of each individual investment with each of the other investments. If it sounds difficult to build a portfolio one stock at a time that satisfies these parameters, especially for an individual public investor, be assured that it is indeed difficult. But don’t fret, as there is an easy method to accomplish this goal for the portion of your investment capital that you allocate to the stock market. A well-qualified financial advisor ought to be able to help you achieve the type of portfolio recommended by MPT for any assets you own that are not stock market related.

Again, it’s important to reiterate that our discussion focuses on only that portion of your assets you have allocated to investing in the stock markets of the world. This book makes no recommendation on how you should otherwise allocate your assets. MPT tells us that asset allocation should not be ignored, as it represents the best method of reducing the overall risk of your portfolio. Numerous books offer advice on how to allocate assets in accordance with MPT, and we’ll leave that discussion to them.

The Prudent Investor
The prudent man rule contains guidelines for those responsible for investing other people’s money. The purpose of the rule is to offer protection to investors by providing those fiduciaries with investment guidelines. Over the years, the rule has changed with the times. At one point, it would have been considered lunacy to invest the savings of a public investor in the stock market. After World War II, as inflation became important in making financial decisions, it was considered extremely imprudent for a fiduciary not to invest in the market. Today it is not enough to merely invest in stocks, and the prudent man rule requires that fiduciaries invest at least part of an investor’s funds via passive investing, using index funds. Passive investing is consistent with the teachings of MPT and represents an important part of our overall recommended investment strategy.

At one time, a fiduciary had the difficult responsibility of being certain that each investment was appropriate for an investor. Today, taking MPT into consideration, the prudent investor rule has been revised to “focus on
the portfolio as a whole and the investment strategy on which it is based, rather than viewing a specific investment in isolation.” As a result, it’s acceptable for fiduciaries to recommend shares that would be risky as standalone investments, as long as the entire portfolio is appropriate for the investor.

Diversification is an essential element when following MPT. The easiest way for public investors to diversify has been to own shares of traditional mutual funds. Their very existence is one reason why so many Americans are currently stock market investors, as mutual funds make it easy for public investors to own a professionally managed diversified portfolio of stocks. The wisdom of relying on these professional money managers is one of the subjects covered in MPT.

This review is from: Create Your Own Hedge Fund: Increase Profits and Reduce Risks with ETFs and Options (Wiley Trading)
This book covers the basics of this strategy very well; however it contains way too much filler information, and not enough substance. The author treats the reader as a novice to the market; but in reality no stock market novice would even begin to understand this strategy - therefore the author misses his target audience!

In my opinion, it is good entry entry-level reading for the market beginner who wants to understand the basics of a hedge fund; however it is not for the seasoned trader demanding greater insight in to a leading-edge strategy.