Modern portfolio theory is the quantified version of “Don’t put all your eggs in one basket?”
Because if you placed all your eggs in one basket, and that basket was damaged, you might lose all your eggs.
In finance we use securities instead of eggs, and we bundle a series of different securities together, so that when some the securities fall in value, other securities rise in equal amount, thus the overall value of the portfolio stays the same, but as markets rise overall, so do the securities’ values along with the market’s rising tide.
Let’s look at the Callan Periodic Table of Investment Returns to better understand the theory.
The chart depicts the annual rate of return for each of the 4 assets classes, equities, fixed income, cash equivalents, and real estate.
If you were to invest 100% of your money into Large Cap in 1999, you would have earned 21.04%, but that next year you would have lost -9.11% for a two-year average of 10.93%.
On the other hand, if you had split your investment between large cap and real estate, for example, you would have earned 14.96% in 1999 AND 4.73% as you can see by subtracting the 13.84% produced by the real estate investment from the -9.11% from the large cap equity. So we can see the power of diversification from this example – “don’t keep all your eggs in one basket.”