Some investors have begun to question modern portfolio theory, which advocates for a method of investing that depends on diversification. Through diversification, modern portfolio theory holds, investors can strike a balance between risk and return on investment. However, the 2008 economic downturn has shaken the belief in this approach to investment, since diversified portfolios continued to languish. However, this loss of faith rests on a fundamental misunderstanding of modern portfolio theory. Through diversification, investors can protect themselves from the risks that come with having all investments in a single asset class.
In 2008, investors with diversified interests in both stocks and high-quality bonds experienced losses, but the bonds mitigated those losses. If all interests had been in stocks alone, portfolios would have experienced more catastrophic losses. In order to illustrate this point, an investor with 60 percent of a portfolio in stocks and 40 percent in bonds - the ratio advocated by modern portfolio theory - would have realized a loss of about 23 percent. Investors with 100 percent of their assets in stocks saw a 37 percent loss. In essence, diversification can significantly soften a portfolio’s losses.
In 2008, investors with diversified interests in both stocks and high-quality bonds experienced losses, but the bonds mitigated those losses. If all interests had been in stocks alone, portfolios would have experienced more catastrophic losses. In order to illustrate this point, an investor with 60 percent of a portfolio in stocks and 40 percent in bonds - the ratio advocated by modern portfolio theory - would have realized a loss of about 23 percent. Investors with 100 percent of their assets in stocks saw a 37 percent loss. In essence, diversification can significantly soften a portfolio’s losses.