How much should I rely on gut instinct when investing?

@Money March 9, 2012: 9:58 AM ET

NEW YORK (CNNMoney) -- I manage my own portfolio. Do I need to use modern portfolio theory to allocate my assets? Or will my gut feel for the risk/return of each asset do? -- David Wilcox, Orem, Utah

Unless your stomach is so finely tuned that it can not only gauge the risk and return of stocks, bonds and other assets, but how those assets interact to determine your portfolio's overall performance, I'd forget about the gut-feel approach.

At the same time, though, you don't want to put too much faith in modern portfolio theory, or MPT, as it's affectionately known.

Typically, investment advisers who use MPT rely on "optimizer" software to help them create a portfolio from a variety of investments -- stocks, bonds, real estate, commodities, whatever. They plug in each asset's expected return, volatility and correlation to all the others, and the program calculates exactly how much of each asset you should put in your portfolio so that, theoretically at least, you'll get the highest possible return for whatever level of risk you're willing to accept.

But what works fine in theory doesn't always turn out so well in the real world. Investors armed with optimizers can often create extreme portfolios that may generate underwhelming results.

The reason is that while the basic info you plug into an optimizer seems simple -- an asset's expected return, how much it jumps around and how it behaves relative to other assets is anything but certain.

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We can calculate those figures for the past. But we don't know what they'll be in the future. If investments perform differently in the future than they did in the past -- even by a small amount -- the portfolio that was so finely crafted using MPT can perform abysmally, much as a racecar designed for the Indy 500 would if it raced on a dirt track.

I recommend a hybrid approach, a mixture of toned-down portfolio theory and common sense that can reap some of the benefits of MPT without overdoing it.

To get a handle on the quantitative aspects of creating a portfolio of different types of stocks, bonds and funds, you can go to a tool like Morningstar's Asset Allocator.

As you drag the tool's sliders to create different combinations of assets, you can see the expected return for each portfolio, as well as its volatility. By trying different asset combos, you can home in on a risk-reward combo that feels right for you.

Or, if you want a simpler approach, you can just go to our Asset Allocation Tool, answer a couple of questions, and you'll get a pie chart with a recommended mix of stock and bond funds.

Now for the common sense part of this approach.

Whatever portfolio you eventually settle on, realize that it's not going to perform exactly as you might hope. Financial markets are uncertain, and no theory, investment strategy or combination of assets can eliminate that uncertainty.

So I'd be wary about creating a portfolio that's highly risky or excessively conservative. You want to avoid a mix of assets that's so aggressive you'll end up abandoning it if the market tanks. Similarly, you don't want to veer so much to the safety end of the spectrum that you relegate yourself to anemic returns over the long term.

I'd also caution against getting too fancy. Some investors feel that to have a well-diversified portfolio they've got to have exposure to every type of fund or ETF out there, not to mention hedge funds, precious metals and other commodities.

Simple is better. You can get by perfectly well with a combo of broadly diversified U.S. stock and bond funds, with perhaps a dash of foreign stock funds thrown in.

If you're intent on also adding a small dollop of real estate funds or even a tiny bit of exposure to commodities, fine. But be careful. As investment adviser and "Stop The Investing Rip-Off" author Dave Loeper points out in "fake diversification," it's a mistake to assume complicated portfolios perform better. He also warns that advisors who recommend them may be doing so to justify lofty fees.

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I can't promise that this hybrid MPT-common sense strategy will lead to superior performance. But if you settle on a portfolio that's diversified but not overly so and reflects your true tolerance for risk -- and you periodically rebalance -- you'll have invested your money in a rational and sensible way.


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