Markowitz says that financial advisors concerned about re-experiencing recent large market losses should optimize their clients' portfolios by removing some risk from the investments and giving up some of the return. Such portfolios would have lost less in 2008, and they would have hit their break-even point in a shorter period.

For example, the S&P 500 lost 38% in 2008 and higher-beta emerging markets indexes fell 54%, he says. Corporate bonds might have fallen in value, but they declined much less than stocks, and government bonds even rose in value (the five-year government bond index rose 8.4%). Small capitalization stocks dropped in value, but not as much as expected, based on their standard deviations. Meanwhile, large capitalization stocks performed worse than expected. Taking all these factors into account, a simple fifty-fifty split between the S&P 500 and the Lehman Brothers Government Bond Index would have lost just 12.5%.

Markowitz, by the way, says he has about 60% of his own portfolio invested in exchange-traded stock funds more heavily weighted toward small companies and emerging markets. The rest is invested in short-term and intermediate-term bonds-not bond funds, which he believes invest in "too much crap." This may sound a little risky for someone his age, but he says, "I feel comfortable and have enough money in municipal bonds so that if I die my wife has enough to live off tax-free income. I can afford to be more in equities."

Over the long run, modern portfolio theory helps advisors spread their clients' risk and build wealth. Nevertheless, the theory is not without critics. A chief complaint is that Markowitz's model assumes asset returns are normally distributed. Frequently, however, stock market returns are not normally distributed. There can be large swings of three to six standard deviations from the mean, and these occur more frequently than they should if the returns were normally distributed. Other research shows that the capital asset pricing model can't always be explained by a portfolio's beta value. Low-beta stocks sometimes deliver higher returns than high beta stocks.

Markowitz disagrees with the critics, saying his model never assumed that the probability distribution would be normal. His research shows, rather, that mean variance portfolio relationships are a good approximation of the expected value of a portfolio.

"It is another myth," he says, "that you can't invest in assets [using modern portfolio theory] that are not normally distributed."
For example, he stresses that derivatives, such as stock options, might be optimized in a portfolio to improve risk-adjusted rates of return as long as a financial advisor has good data on the covariance relationships to other portfolio assets.

Markowitz advises financial advisors to estimate the likely returns, risk and correlations among various asset classes and use these inputs to conduct a modern portfolio theory analysis. "This produces a curve of 'efficient' risk-return combinations. If you want greater return on average, you have to take on greater risk. If you want less month-to-month and year-to-year fluctuations, you have to accept less return on the average in the long run."

It's better to diversify across asset classes as well as within the portfolios, he says, which is more "efficient" than doing only one of these, or neither. For example, riskier portfolios may contain greater weightings in emerging market and small company stocks, based on investment style. Less risky portfolios might be weighted more toward large-capitalization U.S. and foreign stocks, based on investment style, as well as short-term and intermediate-term bonds.

He emphasizes that the shorter the investment horizon, the greater the risk of losses because there is fatter tail risk. But the longer you hold asset classes, the greater the probability the distribution is normal. As a result, two-thirds of the time, returns typically fall between negative 10% and positive 30%.

Be cautious about investing in alternative assets, ETFs that invest in alternatives, private placements and commodities, he warns, unless you have the time and expertise to value them. Those types of investments, he says, are best left to people like Warren Buffett and David Swenson of Yale University's endowment fund.