Updated Friday, October 31, 2014 as of 4:41 PM ET

Does Modern Portfolio Theory Still Work?

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.

4 CHALLENGES

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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Comments (3)
You just cannot use the theory blindly. You need to be well versed with it, understand the rationale behind each of the principles and then evaluate each principle in isolation to see whether it needs to be tweaked in some manner. If the theory could be applied blindly without adjustment, this task would be assigned to a robot and not a financial advisor.
Posted by KIMMY B | Tuesday, November 26 2013 at 2:41PM ET
Gene Fama addressed the question of semi-variance as the true risk measure relevant to most investors: "Let's now examine whether you really believe what you say about your client's tastes. In our (academic) terms, your statements imply that your clients are risk neutral on the upside but risk averse on the downside. If this is the case, the semi-variance, which ignores upside risk, is probably a better single measure of risk than the variance, but the conclusion is subject to the caveats above about the skewness of return distributions for longer return horizons. Risk neutrality on the upside has a strong implication that we don't think characterizes most investors. Specifically, if such a client is faced with a choice between (i) engaging in a gamble with only positive possible payoffs, or (ii) getting the expected (mean) payoff from the gamble for certain, the client is indifferent between engaging in the gamble or taking the sure payoff, regardless of the variance of the uncertain payoffs on the gamble. If the client is indeed indifferent, you have accurately characterized the upside. But if the client says that for extreme gambles of this sort, he/she prefers to have the expected payoff for certain, the client has some amount of risk aversion on the upside." That sure is true for most investors I ever met. In other words, long term the trend is always up; and, most of us would rather take a sure return bet than only a take a bet that guarantees a positive payoff. In the latter case you'd probably never take a risk.
Posted by Michael S | Tuesday, November 26 2013 at 3:10PM ET
MPT works, but it requires skill to successfully execute in a environment where quantitative easing is more determinative of performance than historical precedent. The challenge is not having a formula but an expansive view of the market. Trees do not grow to the sky and fundamental economic calculus can not be ignored.

SCW
Posted by Stephen W | Wednesday, November 27 2013 at 11:04AM ET
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