In the era from the 1930's through the 1970's the standard investment literature primarily focused on "stock value theory." Value theory offered a disciplined approach to investing in stocks. If followed an analytical methodology directed towards figuring out the value of a company by mathematically calculating its intrinsic asset value or its discounted future value. A stock would be attractive if the calculated value was below the current market price. Buying cheap was the way to reduce risk and avoid speculation. Value investing was the doctrine of the time. (The classic text here is Security Analysis by Benjamin Graham, David Dodd, and Sidney Cottle, McGraw-Hill Books, 4th ed 1962).
Toward the end of that era, theoreticians at universities and business schools began wondering about whether investors ended up with the best portfolio using the value approach. It seemed to them that the value approach was too narrow. Its focus was limited to choosing individual stocks. It did not work at logically combining those choices into a coherent portfolio.
The new theories that evolved and embraced in my practice are commonly known as "Modern Portfolio Theory." Work on this subject was considered important enough to earn Nobel Prize awards for several economists, including Harry Markowitz who won the Prize in 1990 after first proposing the theory in 1952. By looking at total portfolios instead of just individual investments the new theories are attributed to starting a new era of investment doctrine.
The idea that a portfolio as a whole can be greater than the sum of its parts works because of the efficiency of diversification, efficient diversification using standard deviation and coefficient of correlation (more on these ratios in later newsletters). According to this approach, in the choice between two stocks of equal return/risk value, it is better to select the one with the most negative correlation to the stocks already in the portfolio. This manages the risk in the portfolio. Theoretically, one could actually manage the risk of a portfolio with the addition of a high-risk stock, if the added stock has a negative risk correlation to that of the portfolio.
In summary, this approach looks at investment risk and reward as a function of the portfolio as a whole, placing the most emphasis on associating levels of return with asset classes, but also paying attention to diversification as a means of managing uncompensated risk within an asset class. My work at building portfolios is with a mix of asset classes to maximize returns, but weighted in such a way as to soften the market fluctuations of asset classes and diversify to offset negative risks associated with any one particular investment.
*Investors should note that diversification does not assure against market loss and that there is no guarantee that a diversified portfolio will outperform a non-diversified portfolio.