Few professional investors would argue with the premise that asset allocation is one of the most important decisions an investor has to make. They may disagree, however, on what is the most effective model to make that asset allocation decision.
The most common asset allocation framework investors have used for many years is based on Modern Portfolio Theory (MPT). Developed by Harry Markowitz in the 1950s, MPT suggests that investors should attempt to maximize the amount of return they can achieve for a given level of risk or, conversely, to minimize the amount of risk required for a given level of return.
One of the central ways to accomplish these goals, the theory says, is diversification among various asset classes and securities.
Classic asset allocation models are traditionally driven by three major conceptual elements—portfolio theory, scientific asset allocation, and the efficient frontier—which combine to provide the foundation for modern asset allocation.
MPT argues that ...