It is not at all uncommon to encounter an advertising banner relating to a mutual fund manager or financial advisor that proudly proclaims adherence to the tenets of Modern Portfolio Theory (MPT), or to extensions of the pioneering work achieved by Nobel Prize winning Harry Markowitz. But what lies beneath the hyperbolic, marketing-driven, vague references to “scientific method” and the technical jargon in which the theory is often wrapped or, rather, shrouded? Just what is MPT and, just as importantly, what is it not?
What it is:
A body of theoretical work, and extensions to that work that suggest a systematic and quantitative approach to evaluating risk and diversification in investment portfolio construction. Application of the theory suggests that, at the portfolio level, risk (a.k.a. volatility of returns) can be reduced by combining assets having similar expected returns but less than perfect correlation in returns.
What it is not:
A portfolio construction “How to …Manual”, a recipe book, or a silver bullet lying on the shelf, just waiting for the elite, financial engineering literate to put to work.
In his landmark 1952 paper, Portfolio Selection, published in the Journal of Finance Markowitz embarked on a mission to quantitatively define risk as security-specific and portfolio-level volatility of investment returns. He further sought to quantify the impact of combining dissimilar assets on portfolio-level volatility of investment returns.
The practical outcome of this work was an improved level of clarity regarding the benefits of asset diversification and the reduction of volatility in portfolio returns gained through combining assets having less than fully correlated returns. Markowitz showed, conceptually and within a mathematical framework, that combining such uncorrelated assets could give rise to a portfolio having a lower level of risk (i.e., volatility) for a given level of expected return. He further demonstrated that specific combinations of less-than-perfectly-correlated assets could enable the minimization of portfolio risk across a range of expected returns … generating an “efficient frontier,” or risk vs. returns curve representing optimal asset combinations that would maximize expected returns for each incremental unit of risk (volatility).
Markowitz’ work provided a useful theoretical and mathematical foundation and framework leading to more than fifty years of academic and applied research related to finance and investment practices. Extensions of MPT include the Capital Asset Pricing Model and the Black-Scholes option pricing model – products of other Nobel Prize winners.
Where investors, at both the Main Street and institutional levels, have gotten into trouble is in the application of MPT and its extensions as a literal recipe book for investing and risk management. Key assumptions underlying models associated with the theory must be relaxed when describing the real and dynamic world. Among these are assumptions regarding perfect information flows in markets, consistently rational investor behavior, normal (bell-shaped) distribution of returns, independence and random nature of price moves relative to prior price moves, and, quite importantly, stability in volatilities and cross-security correlations over time.
Modern Portfolio Theory provides a simple, clear and common sense framework for understanding the benefits of portfolio diversification. However, a proper understanding of MPT’s underlying assumptions and an appreciation of their limitations is critical to any and all practical applications of MPT in the investment world. The streets, now and historically, are littered with the financial corpses of those failing to take good measure of the limitations associated with MPT’s underlying assumptions and related, real-world applications.
