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." ...