Determining clear goals is a part of the investment process that too many people skip, with disastrous results. You must decide at the outset what de… - Burton Malkiel

Portfolio theory begins with the premise that all investors are like my wife—they are risk-averse. They want high returns and guaranteed outcomes. The theory tells investors how to combine stocks in their portfolios to give them the least risk possible, consistent with the return they seek. It also gives a rigorous mathematical justification for the time-honored investment maxim that diversification is a sensible strategy for individuals who like to reduce their risks.

Investors should certainly be aware of new methods of portfolio construction. And high net worth investors might consider adding a multifactor smart beta offering or a risk-parity portfolio to the overall mix of their investments. Factor investing can potentially increase returns at the cost of assuming a somewhat different set of risk exposures than those of a standard broad-based index fund. And investors who are able to accept the added risks inherent in leverage might profitably add a risk-parity portfolio to their set of investments. Such offerings should only be considered, however, if they are low cost and if their potentially adverse tax effects can be offset in other parts of the overall portfolio. And I continue to believe that a broad-based total stock market index fund should be the core of everyone’s portfolio. Certainly, for investors who are starting to build an equity portfolio in planning for retirement, standard capitalization-weighted index funds are the appropriate first investments they should make.

The castle-in-the-air theory of investing concentrates on psychic values. John Maynard Keynes, a famous economist and successful investor, enunciated the theory most lucidly in 1936. It was his opinion that professional investors prefer to devote their energies not to estimating intrinsic values, but rather to analyzing how the crowd of investors is likely to behave in the future and how during periods of optimism they tend to build their hopes into castles in the air. The successful investor tries to beat the gun by estimating what investment situations are most susceptible to public castle-building and then buying before the crowd.