Modern Portfolio Theory?

What Modern Portfolio Theory is talking about is diversification: combining an investment (stocks or bonds) that zigs with another that zags. In the investment realm, diversification is your very best friend. Most investment pros are familiar with something called Modern Portfolio Theory. You should be, too.

MPT is the key to maximizing return with minimal risk. What the theory says is that if you combine asset classes that zig and zag in a portfolio, even though each asset class by itself may be quite volatile, the volatility of the entire portfolio can be quite low.

In fact, in some cases, you can add a volatile investment to a portfolio and, as long as that investment shows little correlation to everything else, you may actually lessen the volatility of the entire portfolio.

Correlation is measured on a scale of minus 1 to plus 1. Two investments with a correlation of 1 are perfectly correlated: They move up and down in sync. Two investments with a correlation of –1 have perfect negative correlation: When one goes up, the other goes down.

A correlation of zero means that there is no correlation between two investments: When one goes up, the other may go up or down; there’s simply no predicting.In the real world, negative correlations of two productive investments are hard to find, but you can find investments that have close to zero correlation.

A good example from history is stocks and bonds.Bonds as a whole generally move up and down independent of stock prices. Some bonds — such as long-term Treasuries — tend to have negative correlation to stocks, generally climbing during times of recession (often in response to dropping interest rates in combination with stock-investor panic that drives up demand for security).But other bonds, such as U.S. high-yield bonds, tend to move more in sync with the stock market.

When choosing a bond or bond fund, you should consider the correlation that your new investment is going to have with your existing investments. High-yield bonds pay considerably more interest than Treasuries, but they aren’t going to give you nearly the same diversification power if your portfolio is made up mostly of U.S. stocks.