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Back to the Drawing Board
Investors are having to rethink the foundations on which they build their portfolios
By
JOHN FERRY AND MIKE FOSTER
Updated April 12, 2010 12:01 a.m. ET
The recent financial crisis has all but torn up the investment rule book—received wisdoms have been found wanting if not plain wrong.
Investors are being forced to decide whether the theoretical foundations upon which their portfolios are constructed need to be repaired or abandoned. Some are questioning the wisdom of investing in public markets at all.
ENLARGE
ROBERT NEUBECKER
Many professional investors have traditionally used a technique known as modern portfolio theory to help decide which assets they should put money in. This approach examines the past returns and volatility of various asset classes and also looks at their correlation—how they perform in relation to each other. From these numbers wealth managers calculate the optimum percentage of a portfolio that should be invested in each asset class to achieve an expected rate of return for a given level of risk.
It is a relatively neat construct. But it has its problems. One is that past figures for risk, return and correlation are not always a good guide to the future. In fact, they may be downright misleading. "These aren't natural sciences we're dealing with," says Kevin Gardiner, head of investment strategy for Europe, the Middle East and Africa at Barclays Wealth in London. "It's very difficult to establish underlying models and correlations. And even if you can establish those, it's extremely difficult to treat them with any confidence on a forward-looking basis."
Yves Bonzon, wealth management chief investment officer at Pictet & Cie., the Swiss private bank, says that you only have to look at the historical relationship between the S&P 500 and the U.S. Treasury market to see the problems with this approach.

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