Asset Allocation Models

Asset allocation models formalize the trade-off between risk and return. MPT, introduced by Harry Markowitz, uses diversification to reach an efficient frontier of optimal portfolios. Post-modern Portfolio Theory (PMPT) extends MPT by incorporating downside risk measures, such as the Sortino ratio, to better address investor concerns about losses. Stochastic Portfolio Theory (SPT) offers a probabilistic framework for understanding market dynamics and portfolio behavior over time.

Risk parity takes a different cut entirely, allocating equal risk instead of equal capital across assets.

Practical implications of these theories include glide paths for asset allocation, which adjust the asset mix based on the investor’s age and human capital. This approach typically shifts from higher-risk investments to more conservative ones as retirement approaches. The lazy portfolios of section “Lazy Portfolios” apply the same theories through a fixed mix of low-cost index funds.