Chances are that if you manage investment portfolios, modern portfolio theory (MPT) lays the groundwork for how you do it. It provides a framework for advisors to help their clients find the best return on their money with the least amount of risk. Conceptually, it allows them to do so by examining the effects of asset risk, correlation and diversification on their portfolio returns and then by prompting them to select a portfolio accordingly.

But this landmark theory of investing was put to the test in 2008, which saw the S&P 500 index drop 38%. So does modern portfolio theory hold up?

The answer is yes, though much depends on how you split up your clients' investment pie, says Harry Markowitz, who won the 1990 Nobel Prize in economics for developing Modern Portfolio Theory in 1952 and 1959. "It is sometimes said that portfolio theory fails during a financial crisis because all asset classes go down and all correlations go up," the 82-year-old Markowitz acknowledges in a telephone interview from his office in San Diego.

But this, he stresses, was already predicted by the theory. "Generally, asset classes move roughly in proportion to their historical betas."

Markowitz teaches the landmark theory at the Rady School of Management at the University of California, San Diego. He's also working on a new book and consults with companies such as investment advisory firm Index Fund Advisors and Guided Choice, an advisor to 401(k) plan sponsors.

When he goes for his daily lunchtime walks, Markowitz notices license plate numbers, and routinely calculates the probability of seeing the same number reoccur. For example, the probability of seeing a license plate with four of a kind such as 6666 is one in one thousand, he says. But every year, if you walk enough, you will see another license plate with four of a kind.

It's the same, he says, with the stock market.

Markowitz advocates optimizing portfolios to get the best return per unit of risk by using asset correlations dating back to 1926, rather than using short-term and current correlations. History tends to repeat itself, he believes, but not in the same sequence. So there is always a chance the investor could experience losses similar to those in 1929, 1987, 2002 and 2008.
"Personally, I think that nature draws from the basket known as the S&P 500 randomly every year," he says. "The stock market losses in 2008 have a probability of occurring about once out of every 40 years. The 38.5% loss on the S&P 500 was more than 2.5 standard deviations below the mean."
Yes, the 2008 market crash could happen again, he says. But you don't know when. The losing cards are in the deck.

Markowitz's theory for allocating assets has been refined by subsequent research. The capital asset pricing model, for instance, designed by William Sharpe in 1963, gave money managers an extra measure of risk to consider. Sharpe's theory considers systematic risk, or how an asset moves in relation to the overall market. Under Sharpe's theory, systematic risk is measured by a portfolio's "beta" value. The market, as measured by the S&P 500, has a beta value of 1. An asset with a 1.2 beta value is about 20% more volatile than the market. By contrast, an asset with a 0.8 beta is 20% less volatile.

Additional refinements were devised by Eugene Fama and Kenneth French in 1995. They fine-tuned the model to account for investment styles, taking into account whether the stock was a large, medium-size or small company, and whether it was a growth or value play. So to reduce volatility today, advisors often use modern portfolio theory to construct portfolios and incorporate a wide range of United States and overseas asset classes.