Portfolio Theory

Building a successful investment portfolio isn’t just about identifying top performing stocks or following market trends. It’s about designing a coherent strategy that balances growth with protection. A strategy that provides guidance in both, periods of expansion and recession. At FinanceGarrison, we believe this balance begins with the principles of Portfolio Theory, shaped by real-world constraints and a deep understanding of investor psychology. This guide provides practical strategies based on what has proven effective for us in the markets.

Each section of this guide includes a Garrison Insight—a practical takeaway based on real-world experience. These insights highlight the strategiesand habits that have worked for us in the markets. They’re not theory or fluff, but actionable advice drawn from actual trading decisions and portfolio management.

Diversification

Diversification is often misunderstood. It’s not about simply holding a large number of stocks. It’s about strategically selecting assets that don’t move in perfect sync. This is, not just investing in a large range of companies but investing in companies that trade in different geographical markets and from different sectors.

According to Modern Portfolio Theory (MPT), diversification allows investors to optimize their portfolio’s risk-return trade-off. When you hold assets that are not perfectly correlated, the overall volatility of the portfolio decreases, even if some individual investments are risky. For this reason, checking for correlation between stocks is a good idea before making any investment decision.

Risk Aversion

The concept of risk aversion helps explain why investors often make suboptimal decisions, like selling during downturns or holding too much cash. This tendency is backed by behavioral economics and was explored in depth by psychologists Daniel Kahneman and Amos Tversky in their seminal paper, “Prospect Theory: An Analysis of Decision under Risk” (1979).

Their research introduced the concept of loss aversion, showing that people would rather avoid losses than chase equivalent gains even when the math says otherwise. Below there is a graph that depicts this phenomenon. For gains and losses of the same amount, losses are perceived as more significant and have a stronger negative impact on a person’s overall utility than an equivalent gain would have a positive one.

Much of the common risk aversion toward smaller investments can be traced to two well-known behavioral biases. The first is loss aversion, where people tend to fear losses more than they value equivalent gains. The second is narrow framing, where individuals consider risks as if there’s only a single possible outcome—similar to flipping a coin once—rather than seeing them as part of a broader range of outcomes, like flipping 50 coins. These two biases together help explain the unique set of preferences described in prospect theory, developed by Daniel Kahneman and Amos Tversky, which was a key factor in Kahneman receiving the Nobel Prize in Economics

Sector Allocation and Geographical Market

Sector allocation is vital to managing risk. Relying too heavily on one industry, like tech or energy, can lead to sharp losses if that sector underperforms. By diversifying across sectors such as healthcare, consumer goods, and financials you smooth out performance across different market cycles and reduce volatility in your portfolio.

Geographic diversification works the same way. Investing across multiple regions like the U.S, Europe, Asia, and emerging markets helps protect your portfolio from country-specific risks and allows you to benefit from growth in different parts of the world. Together, sector and geographic balance support a more stable, long-term investment strategy

Products like the MSCI World highlight the importance of both sector and geographic diversification. The MSCI World includes a broad range of companies across multiple industries and more than 20 developed countries, making it a well-balanced representation of the global equity market. By spreading exposure across different sectors and regions, it helps reduce the impact of localized downturns or industry-specific shocks.

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