Modern Portfolio Theory and the Last 13 Months of Investing

I wrote about the Modern Portfolio Theory in a previous blog. The theory can be summarized by a series of risky investments when combined together yield a greater return with a much smaller amount of risk such that you can approach the return of a risk free investment like a short term treasury bond.

Money moves between investment classes such that wealth is re-allocated rather than be destroyed. Money moves between asset classes such as commodities, US stocks, International stocks, long term bonds, short term bonds, etc...

What I learned during the last 13 months from October 2007 - 2008, when the Dow declined by 44%, was that this theory worked well until June 2008. For the first 9 months things acted normally and diversification worked well. From July through October the theory failed miserably.

In hind sight my blind faith in this theory cost me a lot of money. What I failed to realize is that when things go into a panic and fear abounds the only save place to be is in cash or a cash instrument like a money market account.

From July through October virtually all asset classes crashed. Wealth did not transfer it was destroyed in every class. Long term bonds dropped 25%. Short term bonds dropped 10%. All commodities dropped even gold. All stocks indexes around the world dropped.

Diversification works for 95+% of the time. I believe that diversification is the prudent course of action now. For the other % of time when panic hits it is time to put the theory aside and get in a position to buy at the peak of the panic when few others want to buy.

Be fearful when others are greedy and be greedy when others are fearful.