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What do the terms asset allocation and diversification really
mean? These popular terms may be familiar to you, but lets
explore them further. Basically, the concept speaks to not
putting all of your eggs in one basket and making sure that you
have investments in many different types of companies and styles
to be able to minimize risk and benefit from those areas that
may be doing well.
This concept is the basis of the Modern Portfolio Theory, a Nobel
Prize winning theory based on Harry Markowitz’s work at Harvard
in the 1950’s. Harry was commissioned to prove that the markets
do not work efficiently. What he and his team came to realize is
that the markets do operate efficiently and that while you have
a certain probability of “picking the winner” the odds are
mostly against you. Their theory, later to become the Modern
Portfolio Theory states that over 91.5% of a portfolio’s
performance is based upon proper diversification among asset
classes.
What are asset classes? Asset classes are groupings of
investments that meet certain criteria, for example large cap
style investments are those of companies that have more than $5
billion of common stock outstanding. The most common asset
classes are Large Cap, Mid Cap, Small Cap, Fixed Income and
International. These classes are further broken down into
Growth, Value and various other “styles” of investing.
The
Modern Portfolio Theory holds that only 4.6% of a portfolio’s
performance over time can be attributed to the individual
investments selected or to market timing, that is guessing when
investments are likely to go down (buy) or go up (sell).
As such, investments that represent many asset classes, track
the market(s), and keep costs down, will position the portfolio
optimally for the long term.
For more information on Asset Allocation, Diversification, Asset
Classes, and styles of investing, please ask us for our analysis
on these topics.
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