Modern Portfolio Theory (diversification and asset allocation or "buy and hold" investing) was introduced in 1952 by Harry Markowitz. The fundamental concept behind this “theory” - note it is a theory and not a fact - is that the assets in an investment portfolio should not be selected individually based on their own merits but to consider how each asset changes in price relative to how every other asset in the portfolio changes. With the hope that different assets are uncorrelated with one another so if something goes down, something else in the portfolio will go up and prevent large losses.
The fundamental problem with this investment theory is, during a crash, everything is correlated as investors flee all risk for the safety of cash and gov’t bonds. MPT does not account for Black Swan Events (see page on Black Swans) because they are considered “extreme outliers”. This is precisely the wrong way to deal with them. We must plan for these events and have a strategy to protect ourselves from huge losses because these events play a much larger role in determining our investment success or failure than regular occurrences in the world.
We see some major stock market headwinds facing investors in the future. We commissioned a report on "The 5 Dangerous Trends Facing Investors in the Next 10 Years and How to Avoid Them" in an attempt to educate investors so they are prepared for the next stock market crash. Contact us today for a free executive summary.
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