Rebalancing Your Portfolio: Risky Business

So you've gradually accumulated a bunch of funds over the years, and maybe, after a dismal year, you're vaguely wondering how they all fit together. Perhaps you have too much sitting in tech, or you think you need more bond exposure, but aren't sure how much.

What you should do all comes down to a call on risk, which hasn't exactly gotten much attention during the past few years. There are a couple of ways of thinking about how to structure your portfolio with regard to risk, but the granddaddy of them all is Modern Portfolio Theory (MPT). Since the theory was first advanced in 1952, MPT has transformed the way people think about how to invest. So profound were the theory's implications that its creator, Harry Markowitz, won the Nobel prize in economics in 1990.

Notwithstanding its fancy pedigree, the basic ideas behind MPT aren't that complicated: Essentially, it's that investors must first select their risk tolerance, then look for the portfolio that offers the highest expected return for that amount of risk. MPT also emphasizes the need to diversify across investments to minimize risk. "The two big [investment] lessons from the past are: One, if you have a long-term horizon, be in the market and don't try to time it. And two, diversify," says Jim Peterson, vice president at the Schwab Center for Investment Research. "Modern Portfolio Theory has become the real cornerstone of finance because it focuses on diversification."

So how exactly can you apply the theory to your own investments? The good news is that it has gotten a lot easier since 1952, as the computing power required for doing the necessary number-crunching has surged. But there are still some uncertainties inherent in the computations.

How MPT Works

In theory, figuring out your optimal asset allocation works like this: You go to a financial planner or brokerage and fill out a questionnaire designed to determine your risk tolerance. You might answer questions, for example, about how much money you could stand to lose in a year. Then, using a computer, the financial planner runs what's called a portfolio optimization to figure out the maximum portfolio return that corresponds with your risk level.

But that's where some controversy enters the scene because the inputs in that process involve a certain amount of guesswork. An optimization considers three factors: the estimated returns on particular stocks or funds, estimates of standard deviations in their performance and estimates of the correlations among all the stocks or funds in the sample.

Unfortunately, advances in technology haven't changed the fact that these are extremely tricky predictions to make. That's especially true for the estimates of expected returns for a given stock, which invariably draw to some extent on past returns. But of course, no one can say with any reliability how a stock will perform in the future. "It's very difficult to use historical data to say something about future returns," says Peterson. "Look at any mutual fund prospectus and it will say, 'past performance does not guarantee future returns.' "

And if the estimates of expected return are wrong, the resulting portfolio recommendations won't have much value, Peterson explains. "If the estimates have zero predictive power whatsoever, and you have no ability to say what securities in the portfolio are going to earn relative to each other, then the portfolio weights are meaningless."

In practice, then, MPT isn't as straightforward as it may initially sound, and for that reason it isn't a do-it-yourself undertaking. A financial planner can help you put some of the findings and recommendations of a portfolio optimization in context. An optimization is "really nothing more than a bunch of math equations," says Peterson. "It does exactly what it says it's going to do: [It] finds the highest expected return for a portfolio given the risk you set."

Because it's generated by a computer, though, an optimization won't always translate the results into a sensible investing plan. For example, an optimizer might look at the high returns generated by emerging markets over the past 10 or 20 years and decide to heavily overweight a portfolio in that area. "That's where a finance professional helps out," explains Peterson. "If the optimizer says to put 60% of your investments in emerging markets, the professional can say that's a bad idea." (If you're interested in exploring the idea a little more on your own, one Web site that draws on the tenets of MPT is www.financialengines.com.)

Another Approach

For reasons unrelated to optimization issues, though, some investors decide to venture outside the camp of MPT. Followers of Markowitz's theory believe -- as do most people in finance -- that markets are fairly efficient and security prices reflect the information that's available about them. But not everyone agrees. Investors who think markets are not efficient might load up on securities they consider underpriced in the hope that the market will eventually recognize their value and the price will rise accordingly. In practice, people who subscribe to this idea often load up on a relatively small number of stocks they consider likely to outperform.

A smart idea? Probably not, for most people. In particular, the events of the past year have underscored the potential for this approach to backfire in spectacular fashion: Investors who overloaded on technology got reamed in 2000, and the punishment has continued into this year. For most retail investors, making highly concentrated bets is "a very dangerous strategy outside the context of a well-diversified portfolio," says Peterson. "It is very, very difficult to find hidden gems. It would be a big mistake to dismiss Modern Portfolio Theory because you believe there are some market inefficiencies." Just look at how actively managed funds perform relative to their benchmarks, he adds -- it's rare for such funds to outperform their respective indices over a period of years.

Peterson and others say it's probably wiser to determine your asset allocation with an eye toward diversification, the centerpiece of MPT -- though you could always tweak those recommendations and take a higher-risk approach that aims for fatter returns. Either way, the ratio of stocks to bonds, and of large caps to small caps, will vary depending on your risk tolerance and financial objectives.

Core-and-Explore

Once you have that allocation in hand and you're ready to start building your portfolio, you might want to consider using the core-and-explore approach developed by Charles Schwab. This two-pronged strategy draws on both MPT and a potentially more concentrated approach: It combines diversification with the potential for market-beating returns.

According to the core-and-explore strategy, investors should sock away a majority of their portfolio in a "core" broadly diversified investment, like an index mutual fund, while spreading the remainder across the "explore" portion -- actively managed funds or individual stocks.

By way of guidelines, the Schwab Center for Investment Research recommends that within the large-cap portion of an investor's portfolio (whatever that may be), he or she stash 80% in a core fund and 20% in an actively managed fund or stocks. Within small caps, the core-to-explore ratio is 40% to 60%, and within the international allocation, 30% to 70%. Those percentages reflect the fact that it's more likely for actively managed funds to beat their benchmarks in less liquid markets, like those for small-cap and international equities.

The chart below offers a sample portfolio breakdown for an investor who has $50,000 to invest and fits the aggressive growth profile.

A Sample Aggressive Growth Portfolio
Asset Class	Overall Allocation	Investment in Each Asset Class	Percentage Allocated Core/Explore	Dollar Investment in Core/Explore
Large Cap	40%	$20,000	80%/20%	$16,000/$4,000
Small Cap	25	12,500	40/60	5,000/7,500
Cash	5	2,500	--	--
Source: Schwab Center for Investment Research

Again, these are just guidelines. If you're intent on beating the market, you may want to boost your allocation to the "explore" portion by investing more in actively managed funds. Alternatively, if you want to minimize your risks, you should probably stash more money in index funds or other well-diversified funds.

At both levels -- asset allocation and portfolio building -- how much risk you take is up to you. But whatever you choose, it's worth keeping in mind the trade-off between risk and return.