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Modern Portfolio Theory

To Illustrate the power of a disciplined allocated-assets approach to investing,

Jack Tenney

Two stocks of equal value are purchased in equal amounts. At the end of each year (or any other chosen period) the holdings are valued and rebalanced. That is, shares are bought and sold so that the total value of the holdings is evenly split between the two stocks. In the example, the two chosen stocks perform poorly, neither rising in value above its original purchase price while each stock takes a turn at losing half its value before ending up at the beginning share price.

Had the stocks held for the entire illustrated period, there would have been no gain or loss. Had the losing stock been liquidated and the proceeds invested in the other and then the entire portfolio been sold on the dip, as it were, more than half the original investment would have been lost! However, using the asset allocation method, the two stocks are "sold high and bought low". And, even though "high" is never higher than the original purchase price, a substantial gain is obtained.

01/01/00 BUY ABC $10.00 $1,000.00 100
01/01/00 BUY XYZ $10.00 $1,000.00 100
12/31/00 VALUE ABC $5.00 $500.00 100
12/31/00 VALUE XYZ $10.00 $1,000.00 100
01/01/01 BUY ABC $5.00 $250.00 50
01/01/01 SELL XYZ $10.00 -$250.00 -25
01/01/01 VALUE ABC $5.00 $750.00 150
01/01/01 VALUE XYZ $10.00 $750.00 75
12/31/01 VALUE ABC $10.00 $1,500.00 150
12/31/01 VALUE XYZ $5.00 $375.00 75
01/01/02 SELL ABC $10.00 -$562.50 -56.25
01/01/02 BUY XYZ $5.00 $562.50 112.50
01/01/02 VALUE ABC $10.00 $937.50 93.75
01/01/02 VALUE XYZ $5.00 $937.50 187.50
12/31/02 VALUE ABC $10.00 $937.50 93.75
12/31/02 VALUE XYZ $10.00 $1,875.00 187.50
12/31/02 TOTAL ALL    $2,812.50  
  GAIN ALL   $812.50  

True, a "moderate" commission brokerage fee (i.e. $24.95/trade) or $200.00 in transaction fees would have been incurred reducing the gain from $812.50 to $612.50 (40+% to 30+%). And, if this were a "professionally" managed account then fees might have run another few percentage points. But, if the best your adviser could do is this, no doubt you'd get another opinion.

The famous Harry Markowitz shared his Modern Portfolio Theory with the world more than 40 years ago when the Dow Industrials were, to coin a phrase, knee-high to Trigger's colt. Markowitz won the Nobel Prize for Economics in the early '90s. By the way, his theory is a little more complicated than my example.

Originally published in September 2001 Business People-Vermont