Modern Portfolio Theory is the basis for asset allocation as we know it today. Modern Portfolio Theory, or MPT, was developed by Harry Markowitz in the 1950s. The basic tenet of MPT is to maximize portfolio performance and minimize risk by investing in non-correlated assets. That is, assets that move in different directions from each other.

The most basic asset allocation is stocks and bonds. It is generally accepted that stocks and bonds move opposite each other. When stocks are up, bonds are expected to be down. When stocks are down, bonds are expected to be up. This helps to mitigate volatility; the swings in value of the portfolio. Both asset classes are expected to appreciate over time, but since they are normally non-correlated the portfolio owner can enjoy a more stable value.

In most portfolios MPT is assumed to be utilized. Diversify and watch it grow. This is illustrated by the colorful pie-charts that your brokerage firm or financial advisor prepares for you. These are mostly standardized portfolio allocations and are fairly consistant from firm to firm. A balanced allocation is usually 50% stock, 40% bonds and 10% cash. Younger investors get more stock (an aggressive growth portfolio might be 85%stock/15%bonds) and older people less stock (a retiree might be recommended a balanced allocation). This is all fine and dandy until 2008 comes along. The theory of MPT remained but the implementation of it didn't change with the times.  True diversification comes from non-correlation. Remember that. Look at your portfolio.  How diversified is it?

A stock portfolio should include both domestic and foreign holdings. Decades ago there was less correlation between foreign markets and domestic markets, and it was assumed investing in the U.S. was a better opportunity and was safer. Investing overseas provided diversification, opportunity and greater risk; there was low correlation. Domestic markets were overweighted.

With the further developement of the global economy, the correlation between foreign and domestic markets became greater; some foreign markets even began to outperform domestic markets, and many have over the last decade. But the portfolio models didn't change. You thought you were diversified but really had a stock portfolio where most of the pieces, foreign and domestic, had a high correlation to each other. When your adviser explained the allocation was diversified because you had both domestic and foreign stocks you probably had less diversification than you thought.

The domestic markets peaked in October 2007 and fell for about 18 months; most foreign markets fell right along with them. If you were fortunate to have bonds in your portfolio you benefited, but not as much as in the past. Due to the spectacular and unusual circumstances last year, your bond portfolio probably lost money as well; less than your stocks, but losses nonetheless. That was because the level of fear was so great people moved money to the "safest" investments, ie treasuries and cash. Selling both stocks and bonds made them fall together. Correlation increased. 

True diversification in 2008 meant that you had to work a little harder. Many investors turned to less traditional investments, like commodities and precious metals, to improve portfolio diversification and enhance returns, but this also came with risk. It is vital that investors and advisers understand the nature of the correlation between the asset classes and investments in a portfolio and the risks inherent to ensure that the portfolio in question is truly practicing Modern Portfolio Theory. Asset allocation likely will need to look different in the future. Failure to adapt and achieve true diversification means an investor is probably leaving his or her portfolios fate to chance.