Modern portfolio theory (MPT) attempts to maximize portfolio expected return for a given amount of risk; or minimize risk for a given level of expected return – by carefully choosing the proportions of various assets.
Although MPT is widely used in practice in the financial industry and several of its creators won a Nobel memorial prize for the theory, in recent years the basic assumptions of MPT have been widely challenged by fields such as behavioral economics.
MPT was developed in the 1950s through the early 1970s and was considered an important advance in the mathematical modeling of finance. Since then, many theoretical and practical criticisms have been leveled against it. These include the fact that financial returns do not follow a Gaussian distribution or indeed any symmetric distribution, and that correlations between asset classes are not fixed but can vary depending on external events (especially in crises). Further, there is growing evidence that investors are not rational and markets are not efficient.
There was a time when I posted comments on the blogs of financial planners, trying to make them understand – or at least discuss the possibility that asset allocation and diversification were no longer sufficient to properly manage risk, and that the use of collars would provide guaranteed protection.
I could not get anyone to agree. They either scoffed at the suggestion that their methods were no longer valid, or that using options was unreliable.I suspect the truth is that the planners/advisors make their livings by convincing people to do as they are told by the experts and to continue to pay the annual fees. I don’t believe they cared to learn anything new.
With that as background, I’m very interested in the controversy over MPT (Modern Portfolio Theory). I always want to know who still believes in its validity and who feels that the new world of investing has not treated MPT kindly. In my 2005 book, I was a big supporter of MPT, but today no longer believe the old rules can be successfully applied to an investment portfolio.
Why? Globalization has played a big role in linking various assets and they are more correlated that at any time in history, and it’s difficult to diversify when one accepts that premise. I also believe that this is not our father’s stock market, with computer trading ruling the day. If the big boys can extract billions of dollars every year from the markets by scalping tiny profits with rapid trading, then we know that at some point computers will control almost all trading and that it will be foolish for humans to attempt to compete.
The blog post by quantivity is worth reading if you are interested in details on this topic. The list of references is impressive. quantivity.
The original post contains a long list of articles that are worth consideration “by readers interested in the refuting literature, which recently converged onto minimum variance as a guiding principle for portfolio composition preferential to Markowitz-derived models.”