The stock market crash at the end of 2008 should have served as a wake-up call to trustees who were looking after portfolios of investments. With equity prices falling around 40 per cent on average (on both sides of the Atlantic), the trusts’ next balance sheets would have looked a bit sick. It is many years since the judgment in Nestle v National Westminster Bank told us that trustees had to be prudent and nothing more. With all the wealth of expertise and learned studies about modern portfolio theory (MPT) available to us, some trustees must be keeping their fingers crossed that MPT is not going to be used as ammunition in breach of trust litigation against them for the considerable losses that were incurred.

MPT is a theory of investment that attempts to maximise portfolio expected return for a given amount of risk, or, looking at it the other way round, tries to minimise risk for a given level of expected return, by carefully choosing the proportions of the component assets. It tracks the correlation in behaviour via price movements as between pairs of investments. Perfect negative correlation (-1) means the two securities move in precisely opposite directions. Perfect positive correlation (+1) means the two securities move in exactly the same direction. Zero correlation means the two securities move randomly with respect to each other.

Consider a portfolio that holds two risky stocks: one that does well when there is a long, hot summer and another that earns increased profits when the winter never seems to end. A portfolio that contains both assets will have less overall risk, regardless of what happens to the weather. The share price movement of both stocks might be dramatic in opposite directions but, overall, one cancels the other out. It is not just about picking stocks, but about choosing the right combination. Coke and Pepsi would certainly not be examples of negatively correlated investments. The problem, however, is that it is nearly impossible to identify securities with perfect negative correlation. All we can do is try to avoid the opposite. Diversifying by correlation does help prevent all your portfolio components from tumbling downhill together.

MPT, developed by Harry Markowitz and first described in 1952, also says that by investing in more than one stock, an investor can reap the benefits of diversification. Put simply, not putting all your eggs in one basket. But how many is enough? The Nobel Prize winner spoke of between 12 and 20 stocks. More is fine, but will not reduce the overall risk.

Although MPT is widely used in practice in the financial industry (and examined in the STEP Offshore Diploma exams), in recent years the basic assumptions of MPT have been challenged. It has been argued that correlation between certain asset classes is not permanent but can vary depending on external events. MPT also assumes that investors always act rationally and that markets are efficient at reacting in a predictable manner.

Correlations can change over time and in different economic conditions. For instance, in the late 1990s, share prices increased significantly then crashed in 2000. Interest rates were lowered, which caused real-estate prices to increase significantly from 2001 to 2006. Hence, real-estate prices were increasing while stocks were either declining or increasing at a much lower rate. This reflects the general negative correlation between the stock market and the real estate market.

‘MPT is not just about picking stocks, but about choosing the right combination’

The real-estate market was forming a bubble due to the extremely low interest rates at the time. The bubble finally burst in 2007/2008, leading to the credit crisis in September 2008. This caused money to move into commodities, which formed another bubble, with oil prices, for instance, reaching USD147 per barrel. The fast increase in prices was not due to demand, but due to the transfer of money from one asset class to another. However, as credit dried up, because of the prevalence of many defaults of subprime mortgages, almost every investment came crashing down in September and October 2008: real estate, stocks, bonds and commodities. Only US Treasury Securities, which are virtually free of credit-default risk, rose significantly in price, driving their yields down proportionately, with the yields of short-term Treasury bills almost reaching zero.

In summary, the message must be that diversification is helpful to reduce risk but correlations can and do change, and that all investments always carry some risk. All we can do is take proper advice and constantly monitor our portfolios.