Already more than two millenniums ago the Talmud recommended splitting one’s assets: One-third should be invested in land, one third in business, and one third should be kept liquid.

Only in the years of 1960 to 1980 a scientific basis for the portfolio theory was created. In 1952 and 1956 Harry M. Markowitz published some essays and in 1959 he published a book about portfolio selection.

Markowitz modeled the diversification mathematically and studied applying computer algorithms to calculate efficient portfolios. He discovered something that should revolutionize the entire financial management: You have to distinguish between a portfolio’s risk and the risks of the individual assets. The risk of a portfolio is not equal to the average risk of the components, but much depends on the covariances (the relationship between two variables - editor's note) of the individual returns. In 1990 Markowitz was even awarded the Nobel Prize for his conclusions.

Today's turbulent times that are dominated by the financial crisis, require investors’ special competence and skills – those who want to cope with the current global recession as well as possible, should seek a balanced, largely diversified portfolio, in order to better distribute the risks.
 
Individual investments should not be considered isolated or one after the other, but simultaneously. Because the advantages of a single investment do not only depend on itself and its’ characteristics. It is important which financial investments the investor also holds with which he combines the considered investment. The individual financial investments and bonds must be evaluated simultaneously and from a uniform perspective.

To achieve this, the selected investment instruments should correlate with each other as little as possible, which means they should develop as independently as possible. As trends in the capital markets are hard to predict, at best all asset classes should be represented in the portfolio. Those, who cleverly combine the elements of their portfolio, can not only balance the financial opportunities and risks, but also influence the overall return. In general, it is said that the portfolio structure has almost 80% impact on the overall return, while the selection of the individual titles only has about 20% impact on the success. Therefore, before looking for suitable individual values, you should decide which importance should be devoted to the individual asset classes.

Today the range of possible investments is very large. First of all there are securities traded at the stock exchange such as bonds and stocks, because they can be sold quickly and therefore optimally satisfy the desire for liquidity. The same applies to instruments which relate to bonds and equities, such as funds and index-related certificates. In addition to bonds and stocks there are real estate funds, real estate investment trusts (REITs) and real estate stocks. Investments in foreign currencies (foreign exchange), gold and raw materials also have a very high liquidity and are therefore also recommended - they are traded on stock exchanges and online via direct brokers. Therefore bonds, equities, real estate investments, certificates, foreign currencies and raw materials have good liquidity.

However, there are great differences concerning the return assumption related to these classes of assets – such as bonds, equities, foreign currencies, real estate, raw materials. Moreover, the differences in the security (related risks) suggest that combinations or just portfolios may be more appropriate than the exclusive investment of the entire amount in a single instrument.

By means of a mixed investment single negative developments and simultaneous positive developments with different investments are compensating each other. This is called diversification. A mixed investment even allows to have investments with high risks in the portfolio. Even less liquid investments are possible. These include for example direct investments in real estate, shipping and private equity.

On the basis of the theory of Markowitz there followed more scientific approaches by Sharpe, Tobin and others about 1960. The then created foundation is nowadays known as the Modern Portfolio Theory (MPT). The MPT was revolutionary at that time. It has given a new direction to the scientific research and fundamentally changed the process of the portfolio management. Scientists such as Markowitz and Sharpe broke with all traditional approaches and completely re-invented the portfolio theory. For this, they applied some quantitative ways of thinking.

The main problem with investing money is to deal with the natural insecurity of future returns.

The returns on the securities are regarded as random variables defined by their expected values, standard deviations and correlations (the direct or reverse flow of securities prices).

The preference of investors focused on considering the expected value and standard deviation of portfolio returns. Whilst the highest possible return is desired, the standard deviation of return is not welcome. Because the larger the standard deviation of return is, the greater is its volatility and the bigger is the risk. The expected portfolio return should be as high as possible, the standard deviation of portfolio return - which stands for the risk - should be minimized.

Considering these assumptions, one can develop a rich theory. The MPT applies probability theory, statistics and mathematics. It provides quantitative tools and methods to diversify risks and to maximize portfolio returns with limited risk.

Therewith an important tool for the finance practice is arising. Portfolio managers often invest other people's money. Therefore, they have to justify their decisions to third parties. That is why they do not follow their own mood or intuition. They use models and methods, whose validity is accepted in professional circles.

The investment environment and what is happening in the financial markets is influenced by many coincidences that in every individual case may bring as well good as bad luck. Those who pin their hope on this, can ignore the scientific approach. In the financial world there is no mysterious "trick" which would be only known to some selected individuals and no one else. The science holds a clear position on this: the investor can only expect a higher return, if he accepts to take a surplus of risks.