The "Single Basket, Multiple Eggs" Quandary

After closing at a record high on October 9, 2007, the Dow Jones Industrial Average proceeded to lose over 53% of its value over the next 16 months. As if adding insult to injury, the ‘07-’09 losses occurred just a few years after the Dow fell close to 38% during the dot-com debacle of ‘00-’02.

It doesn’t matter that the intervening five years were good for stock investors. The combination of these two huge bear markets within the past decade has probably caused many individuals to give up on stocks forever.

Modern Portfolio Theory to the Rescue

Individual investors have been told that market losses like these can and do occur, and the way to prepare for these losses is to diversify your portfolio. While I don’t doubt that smart investors have always avoided “putting all their eggs in one basket” so to speak, most investors - individual and professional alike - currently use Modern Portfolio Theory (MPT) as the basis for their diversification decisions.

The basic idea behind MPT is that investors face two types of risk: the individual risk of each holding (unsystematic risk) and the risk of the entire market (market risk). MPT states that the individual risk of each holding decreases as the number of individual holdings increases.

According to MPT, if you hold a sufficient number of individual investments, unsystematic risk will be diversified away and you’ll only be left with market risk. Harry Markowitz, the father of MPT, argued that the more diversified a portfolio, the lower the risk.

Most advisors - myself included - heed this advice and recommend mutual funds (and ETFs) over individual securities and recommend holding a mix of different asset classes like US stocks, international stocks, bonds, real estate, etc. The idea is is to have one investment that “zigs” when another one “zags” in order to cut down on risk and increase your potential return.

In Summary

Many investors that have given up on stocks after the last two bear markets were either chasing "hot" investments or had too much money in stocks rather than in more secure holdings like bonds. Although it's not foolproof, the MPT theory of investing across multiple asset classes and holding a diversified mix of investments in each asset class can reduce the risk of suffering large investment losses.

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