Modern Portfolio Theory: Is it Disproven?

From Wikipedia

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 They either scoffed at the suggestion that their methods were no longer valid, or that using options was unreliable.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.”


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9 Responses to Modern Portfolio Theory: Is it Disproven?

  1. Robert D. 04/27/2011 at 6:10 PM #


    FYI, here’s a similar article that appeared today:

    • Mark D Wolfinger 04/27/2011 at 6:34 PM #


      In my opinion, writing as a trader and not as an academic researcher, the research paper that he quotes is a pile of garbage.
      No one is his/her right mind would make the trades REQUIRED by the (in hindsight) collar strategy chosen fora the study.

      For that author to say: “This “collar” refers to a combined stock-and-options strategy that has historically walloped the market while also protecting investors from losing their collective shirt during financial panics,” demonstrates to me that he is incapable of understanding what he reads.

      I wrote about this well-intentioned, but trading-ignorant, research paper when it was first published. I was a fan for a short time, but quickly published an addendum, stating how foolish the findings were.

      Thanks for sharing

      • Robert D. 04/27/2011 at 9:42 PM #

        Thanks for your excellent critique of these findings.

        • Mark D Wolfinger 04/27/2011 at 10:07 PM #


          It’s easy to accept academic studies, and I have nothing against them. But sometimes common sense overrules the requirements of the study (sell those 2% OTM calls)

          I thank you

  2. Christopher Smith 04/28/2011 at 8:39 AM #


    I agree with your hypothesis concerning MPT. As I am sure you’re aware, the CBOE has developed hypothetical indexes such as their Buy/Write Index (BXM), 2% OTM Buy/Write (BXY), and a Put/Write index. All three use the S&P 500 as an underlying.

    From Jan. 31, 1991, to Jan. 31, 2011, (20 years) all three indexes either match the S&P 500 or beat it on an annualized basis. Even better, the enhanced yields come with the added benefit of as much as one-third less portfolio volatility.

    Now the part that really surprised me is that the Citigroup 30-year Treasury benchmark had a higher standard deviation than the BXM or the Put/Write index and was lower than the BXY by only .4%, while under performing all of these indexes on an annualized basis. I would not have guessed that.

    One more surprise, the CBOE S&P 500 95-110 Collar index under performed the Citigroup 30-yr Treasury by .6% but also had a standard deviation that was 1.3% lower.

    The conclusion? Write puts or covered calls instead of just going long the equity and trade collars instead of owning bonds. The result should be a portfolio that meets or beats a traditional stock and bond portfolio on a yield basis while cutting portfolio volatility by as much as one-third over owning a diversified basket of stocks.

    The disturbing aspect of this is that all of the information referenced above is freely available from the CBOE’s website. If your financial adviser has read this and continues to insist upon MPT as being the best and most risk averse investment approach I would be really curious to hear the reasons why. On the other hand, if they have not read this material – why haven’t they?

    Good post, Mark.

    • Mark D Wolfinger 04/28/2011 at 8:55 AM #


      It’s nice to hear from you.

      That data point about the 30-yr Treasury benchmark is a surprise. Would never have guessed that.

      Your conclusion, and the message that I have tried to publicize to the financial planner/advisor community, are the same. They do not want to hear any of it. One of these guys is a well-known author who spews words such as ‘skewness’ and ‘kurtosis’ to claim that put options re overpriced.

      I believe it is very simple: They have clients who pay for money management and if the advisor change methods, it could be looked upon as an admission of past incompetence. My guess is that the clients come last and these guys take care of themselves first. Why not – isn’t that the standard mantra on Wall Street?

      Thank you for sharing

  3. Garth 04/28/2011 at 5:23 PM #

    Thanks for the link to the quantivity blog Mark.

    I’ve been looking more towards purely mechanical methods over the last 12 months or so, in an effort to reduce the time factor of my trading business.

    This will give me some excellent reading material.

    • Mark D Wolfinger 04/28/2011 at 8:44 PM #

      Thanks Garth

  4. GS test demo 04/01/2013 at 1:40 AM #

    Modern Portfolio Theory: Is it Disproven? | Options for Rookies

    Not disproven. But there is a ton of evidence that says it is not an accurate theory. I no longer believe in MPT.