INVESTING: Modern portfolio theory may spawn mediocre returns

A tenet of modern portfolio theory is the call to diversify. Over the long haul, equities have gone up twothirds of the time. That means losses have occurred onethird of the time-and they’ve sometimes been severe. Hypothetically, a greater mix of asset classes should protect against the downside and perhaps even provide a portfolio with gains even when equities are down.

But diversify into what? Thirty years ago, when modern portfolio theory was just gaining ground, investors had few choices. Until the mid- to late 1980s, most pension funds, public and private, stayed largely invested in the bond market. As recently as the early 1990s, it was a major decision for investment committees to drop fixed-income exposure from 80 percent to 50 percent and increase equity investments.

Increasing exposure to stocks almost entirely meant large-cap U.S. equities. In the rare case of an enlightened investor who wanted to invest more overseas or in assets like commodities, his choices were limited and access was difficult and expensive. That was the stuff of headlines and people like George Soros, but the average institutional and retail investor typically kept it simple.

By early 2000, endowments and pension funds, along with most retail investors, found themselves holding 25 percent of their money in the bond market with the rest in stocks. The stocks were primarily companies like General Electric, Microsoft and Cisco. Pension funds quickly learned a hard lesson from the concentration, and raced to further embrace modern portfolio theory and diversify even more.

By 2001, we began to see the rising popularity in asset classes like private equity and venture capital. At about the same time, the outperformance of small-cap stocks and commodities won them a spot on the list of assets investors had to have.

Next came a heavy concentration of foreign investing, followed by an increasing focus on commercial real estate. Today, a typical pension fund holds more than a dozen asset classes. And the thirst for additional asset classes grows. Global commercial real estate is the class de jour. If Wall Street can find a way to create an institutional-quality product that tracks the melting of the polar ice caps, funds all over the country would line up to buy it.

Portfolios often reflect the intermediateterm past. Investors now are diversified to their heart’s content. And this strategy has worked over the intermediate term because most things have gone up.

But has this approach truly decreased the risk while allowing for outperformance? My guess is, this strategy actually has increased risk while delivering mediocre returns. My theory won’t be tested until the next bear market arrives, and I don’t expect that for four to six months and quite possibly much further out. In the meantime, trying to squeeze everything you can out of whatever time remains in this bull market means not following the herd.

Concentration in the strongest sectors should lead to better risk-adjusted returns. For the next several months at least, that means energy, industrials and health care.