Modern portfolio theory (MPT) provides investors with a mathematical model to maximize returns and control risk and diversification is its central building block. Investments spread across many assets to minimize overall portfolio risk is the guiding principle.
MPT assumes that correlations among investments don’t change, but reality doesn’t always follow through. The Asian Financial Crisis of 1997, for example, demonstrated how otherwise polarized economies and markets can operate like that when things get hard.
The Theory.
The theory of portfolios in the modern world focuses on allocation and diversification. Investing across asset classes and rebalancing them often are all the tricks to maximizing investment returns and minimising risk in today’s portfolio theory.
For building a portfolio, economists draw on expected returns for asset classes and expected volatility or risk of different classes. With these data in hand, economists then construct optimisation models to guide investors in selecting the best mix of assets with the right combination of return and risk for their particular investment strategy.
MPT does not necessarily equate with the dynamics of real world financial markets and could be misused. Thus, we recommend considering alternative portfolio management theories, such as Post-Modern Portfolio Theory or behavioural finance; however, MPT is still a strong tool that should not be underestimated by investors when balancing risk across investment portfolios.
The Methods.
MPT is the mathematical basis for creating an optimal portfolio of return, at a sustainable risk using diversification. Sophia developed her portfolio out of non-correlated assets, which meant greater potential for returns depending on Sophia’s tolerance for risk.
MPT focuses on correlation as a component. Estimates indicate stock returns aren’t flat but rather unpredictable “fat tail”. Therefore MPT incorporates correlation between assets in designing an optimal portfolio — Sophia’s new portfolio now includes her art gallery, public stocks (technology companies), fixed income such as corporate bonds, and green tech funds that are not correlated with each other.
The Results.
Nonetheless, Modern Portfolio Theory continues to serve investors well even if it’s hampered by weaknesses and does not give an account of risk tolerance in determining how to outweight stocks and bonds.
Contemporary portfolio theory stresses that a portfolio should be built on the way securities interact, not on the individual features of each one, in order for the portfolio to remain diversified and survive short-term market movements. This makes them make stronger investments with better market resilience.
But this analysis is built on assumptions about market behavior that are not necessarily accurate. For instance, it takes for granted that investors are sane and markets are efficient – two facts frequently challenged in behavioural finance studies – and it uses historical forecasts that might be underestimating future market conditions. It does not take into account downside risks – that is, two portfolios of equal volatility may lose more than you think.
Conclusions.
Contemporary portfolio theory transformed investment philosophy, but it’s not without its faults. Critics contend that it assumes presumptions about markets – for example, normal distributions of asset returns and static correlations that simply aren’t true in real markets – that can be misguided and can result in investment failure.
MPT also falls short because it focuses on individual securities instead of evaluating their relative strength, without accounting for the fact that assets do co-move, and that reducing correlation between classes can reduce risk without impacting returns.
MPT doesn’t consider transaction costs, taxes, liquidity limitations, or behavioural biases when constructing portfolios, as they have a big impact on whether an investor meets his/her objectives and should be considered in building portfolios. MPT is therefore not to be used as a system to best make investments but together with other techniques for optimal performance.
