The dramatic volatility and portfolio declines of the financial crisis led many advisors to
blame modern portfolio theory. Yet after a careful look at its principles, itís obvious that they are sound. Rather, itís the application of these principles that is the challenge.
The booming stock market rally of recent years makes now a prudent time for advisors to revisit what we learned about modern portfolio theory and apply those lessons -- before we find ourselves in the middle of another down cycle when mistakes snowball.
Before diving into the current challenges, letís first quickly review modern portfolio theory's core principles.
- Investors are risk adverse.
- Markets are efficient.
- Asset allocation supersedes individual security selection and/or market timing.
- Investing is for the long term.
- Every level of risk has an optimal allocation that maximizes returns.
- Diversification can eliminate specific security and industry risk. Correlation matters.
It is difficult to dispute these underlying principles, which are still as relevant as when they were conceived by Nobel Prize winner Harry Markowitz.
What challenges advisors today is not the core theories themselves, but their application in developing properly allocated portfolios for clients.
Advisors using mean variance optimization to determine asset allocation face four primary challenges: standard deviation, correlation of traditional asset classes, new economic factors and fees.
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