But introduce the possibility of some meaningful change in the expected circumstances, and overlay it with a valuation that is more optimistic than any we've seen since WWII, and you may have a new set of risks and the justification for a new approach to pursuing return and managing risk.

If, in fact, the stock market as a whole is overvaluing our economic future and/or underestimating its risks, perhaps the sun has already begun to set on the efficient market premise of modern portfolio theory. Although MPT's principle that diversification reduces risk remains indisputable, it may be worth re-examining its widely accepted notion of diversification.

New Approach To Diversification

I believe that future "circumstances" are unlikely to be as fecund as those of the past 60 years. A survey of concerns would include: aging populations in the industrialized West, rising cost of government, soaring debt service costs, overcapacity and globalization, beggar-thy-neighbor currency policies, trade imbalances and military concerns.

As Peter Bernstein likes to insist, we cannot know what the future will bring. I realize that there is always trouble someplace on the horizon, much of which blows over and some of which our resilient economy handles well. Nevertheless, as I weigh the current crop of concerns against a market valuation that seems to anticipate an economic future even better than the past, I am uncomfortable with the MPT idea of embracing stock market risk with the majority of our clients' retirement assets. Because I expect an environment of P/E compression, a better idea seems to be to minimize market risk as much as possible and, instead, to embrace selective business risk as a possible source of excess returns. This is the exact reverse of MPT's approach. If we want to minimize market risk, we need a different approach to diversification. Here is our approach.

Rather than begin with an allocation between equity and debt, our first-cut distinction is between what we call Safe Assets and Risk Assets. We call safe those kinds of securities where returns are expected to be stable and unexciting. The makeup varies depending upon available yields; the actual percentage allocated to safe assets is determined by the overall portfolio return our clients need to achieve their personal goals. Safe assets consist primarily of well-diversified, liquid, short-and medium-term, high-quality debt positions.

Risk assets are ones where we realize that there will be volatility and things can go wrong, but where the return potential seems appropriate to the risk. These can include individual equities, actively managed focus funds, limited partnerships of various kinds, leveraged portfolios such as closed-end preferred stock funds, TIPS, lower-quality credits and non-callable long-term bonds where the greatest risk is the sensitivity to interest rate changes.

Having decided on our allocation between safe and risk assets, we then make an effort to diversify our risk holdings based on how each would be affected by the different possible economic scenarios that the future may bring, and we overweight those investments that would do best if our highest-conviction scenario comes to pass. In this way we acknowledge our inability to know what the future will bring, yet we try to add value through our understanding of the way the world works.

We have been developing a grid in which to analyze our diversification, based on three generic economic scenarios: Recession, Muddle and Growth. Each investment is color-coded to the scenario in which its returns would be highest. We make a further effort to understand how each security's return might be influenced by inflation, deflation, changes in the yield curve and such other variables as we can array on our grid. In this way we are satisfied that without having to own every style box or every geographic region we can enjoy the benefits of true diversification, yet hope to realize portfolio returns greater than (what we believe to be) an over-priced equity market can provide.

Our goal of preferring specific risk (business risk, interest risk, inflation risk, etc.) over market risk as a source of returns has led us to a) Do our own securities research on individual equities; b) Favor actively managed focused funds over mutual funds with hundreds of stocks; c) Consider occasional positions in Rydex Ursa (essentially shorting the S&P 500); d) Become comfortable with illiquid issues; e) Place greater emphasis on the micro-cap universe; and f) Favor upfront cash returns from dividends.

Modern portfolio theory's strategy is a lot easier to implement than our scenario-based allocation process and our effort to prefer business risk over market risk, which may partially explain MPT's continuing popularity in the face of so many academic studies suggesting disappointing future results.