Separation property is a theory that is often used to determine the focus and content of an investment portfolio. The theory essentially addresses two key components within the portfolio, and can be applied to any investor’s situation, since these components are considered universal. Proponents of this approach claim that using the separation property model makes it easier to compile a functional portfolio that is likely to help the investor achieve his or her financial goals. By separating the two components and considering each one in turn, it is considered possible to achieve a more balanced portfolio that is capable of producing equitable returns over the long term.
The first component of separation property has to do with assessing the optimal risk inherent in the portfolio. Sometimes referred to as the optimal risky portfolio component, this consideration is focused primarily on the mathematical aspects of the configuration of the portfolio. That is, the mathematical relationship between the investments held in the portfolio is assessed, with a determination made as to whether or not the dynamics of that relationship result in an acceptable degree of risk. For this component, only those investments that carry an appreciable degree of risk are under scrutiny.
Personal choice has a great deal to do with the second component of the separation property model. Unlike the optimal risky portfolio portion, the personal choice is not focused on the overall mathematical efficiency of the investments held by the investor. Instead, the focus is on obtaining the best mix of different types of investments possible, while still keeping the investor’s personal feelings about risk in question. Here, the degree of risk aversion of the individual is taken into consideration, making it possible to buy and sell investments to create the best balance between relatively safe investments and risk-free assets, and those that carry a higher degree of risk. If successful, the portfolio will generate a steady return while not causing the investor any undue concern about assuming too much risk with any one investment.
There are those who promote the theory of separation property as the ideal basis on which to build any type of investment portfolio. Others are not quite as enthusiastic, since it is felt that this approach does not allow much room for the instincts of the individual investor, or that the emphasis on mathematical relationships is either overstated or simply not that important to the overall investment process. In any case, many investors have successfully utilized this basic two-part approach, and found that the efforts did strengthen the integrity of their portfolios, providing them with a greater sense of financial security than they had experienced prior to implementing the process.