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Investors come in many shapes and sizes, bringing with them differing goals, approaches, beliefs and moral convictions. There are at least as many investing styles as there are people investing, but despite this diversity, all investing boils down to one thing: Managing risk and reward. A number of scholars have researched the ideal way to construct a portfolio, which would theoretically provide the highest possible reward at the lowest possible risk. Responsible asset allocation is the cornerstone of long-term investing, and as such it is quite useless for technical traders such as the HFT guys and the algo's. Perhaps this alone is enough to recommend its study. In this first article of a series I will try and outline some of the basics of asset allocation.

The core theoretical current on the topic of asset allocation is referred to as "Modern Portfolio Theory", or MPT, which was devised initially by Harry Markowitz and outlined in his 1952 article "Portfolio Selection". According to MPT, securities should not only be assessed on their own merit, but should be analyzed in terms of how they interact with other elements of a portfolio, or in other words, one should keep in mind how different assets are correlated. Taking these correlations into account allows the investor to construct a portfolio with the same expected return but a lower risk than a portfolio in which these considerations were ignored.

The construction of the ideal portfolio depends in no small measure upon the willingness of the investor to assume risk. The spectrum of risk tolerance runs from the 'London Whale' who gambled billions of dollars on a failed hedging attempt, to a pensioner grumbling about the near-negative returns on Treasury bonds. Investors concerned with safety must sacrifice potential returns, while inversely, investors looking for higher returns must sacrifice certainty and stability. According to Markowitz's book (1959) it is asking too much of an analyst to expect him to predict the direction of a security with any certainty. It is this inherent uncertainty of the market, one of its most salient features, that allows investors to make money. What an analyst can be expected to do is make informed statements about the relations between securities, such as which are higher risk, more volatile or which have higher potential.

For the purpose of this discussion, the most important feature of securities is the correlation between their movement. Most of the time, securities within asset classes move in relative unison, but the precise correlation within this chaotic system is as of yet impossible to predict. In order to contain risk, a responsible investor is thus aware of correlations between securities and uses these to protect their portfolio. After all, a set of positively correlated securities will provide little protection against big market swings, and won't provide much more spreading of risk than a single security. This is the investing equivalent of the commonsense proverb that advises you not to keep all your eggs in one basket.

So what is the well-warned investor to do? Thomas M. Idzorek of Ibbotsen Associates defines the set of asset classes into which funds should be allocated as follows: Cash or U.S. Treasury Bills, Treasury Inflation Protected Securities (OTC:TIPS), U.S. bonds, international bonds, real estate, U.S. stocks and international stocks. A growing number of researchers and analysts advocate adding commodities to this list. While this summary is by no means exhaustive, it provides a useful guide for making your own selection of carefully balanced securities.

The real question is, of course, what percentage to allocate to each class, and which securities specifically should be included. Percentage allocations are largely a function of the investor's risk tolerance. An offensive portfolio would be heavily into stocks, a few bonds and a bit of cash. A conservative portfolio would be largely in cash and bonds. The two most important things to remember here are not to gamble with money you can't afford to lose, and not to take on more risk than your personal financial resources and family situation can bear. Greed is an unattractive emotion, and can cost you a lot more than money on the stock market.

The matter of selecting individual securities has gotten a great deal easier in recent years with the advent of a financial product called an Exchange Traded Fund, or ETF. For a fee, the fund manager will take care of the difficulty and humdrum of stock selection, often by attempting to track a particular index. The great advantage of ETF's over conventional investment funds is their liquidity and transparency. Trading much like a stock, positions can be opened and closed very quickly if necessary. Quite specific information is available about the holdings and performance of the fund, a feature often unavailable with regular funds.

ETF's track a dazzling array of underlying securities, ranging from broad market indexes to niche markets. SPDR S&P 500 ETF Trust (NYSEARCA:SPY) is one of the most popular products, tracking the S&P500 index. By volume, it is one of the most heavily traded securities worldwide. IShares Barclays 20+ Year Treasury Bond Fund (NYSEARCA:TLT), which tracks longer dated U.S. Treasuries, is another very popular ETF and a cornerstone of many fixed income portfolios. Because of their flexibility, diversity and ease, ETF's are an easy way to quickly construct a balanced portfolio.

In this first article of a series, I have tried to explain some of the basics of asset allocation. Following Modern Portfolio Theory, it has become tried and tested wisdom that a well-balanced, responsible portfolio is one in which asset classes are negatively correlated with each other. This premise provides far greater protection against major market swings than a portfolio which is not correlated, or one in which these correlations are poorly understood. In order to allocate funds effectively, various authors have written about the best mix between stocks, bonds, commodities and real estate. In the following articles of this series, I will go into more depth on how money should be divided over the major asset classes, as well as the ways in which ETF's can be used to achieve a responsible allocation.

Source: On Modern Portfolio Theory And Asset Allocation