Modern Portfolio Theory: How Modern is it?
Modern portfolio theory is a mathematical strategy to minimize investor risk. It measures risk against return by allocating diverse assets in a portfolio. The markets are volatile. The upturns and downturns can be extreme. Every broker tell us to think about long-term gains. But that doesn’t settle the nerves of risk-averse investors.
Enter modern portfolio theory – back in 1952.
The Premise of Modern Portfolio Theory
Modern portfolio theory is a mathematical theory put forward by Nobel Prize winner Harry Markowitz, 69 years ago. The theory’s foundation builds is built on six core assumptions.
1. The proposition that all investors are risk-averse. It’s an interesting statement and true for the most part. But advances in technology offer insights that were unheard of in 1952. Not all investors are risk-averse. Some are very bold. What this statement refers to is risk as it relates to return.
2. The assumption that all markets are efficient is the second building block. Poor market performance during the past two years, including accounts built on MPT, makes this questionable. Valuations of assets are neither uniform nor accurate. External conditions can drastically impact prices and value, as with the pandemic. Technology referred has also increased the potential for insider trading and market manipulation. More variables that Markowitz couldn’t begin to factor.
3. Assumption three is that investments are long term. This provision is accepted as true whether your account follows MPT or not. If you plan to make money, in the stock market especially, there will be bull and bear markets. Investors should expect to ride them out.
4. The next assumption is that asset allocations supersede security selection. Asset allocation is a strategy to choose the mix of assets in a portfolio. The mix will include non-correlating assets that perform differently in different market conditions. (These assets might include REITs or Gold which are not as affected in market swings.) Once the asset allocation is complete, the assets – such as mutual funds or ETFs – get chosen for the portfolio.
Again, this is not unique to MPT, but might have been when the theory was first published. Asset diversification is based on predictive analytics. Forecasts are just that – predicted events – not facts. An element of risk remains, but with less chance of a volatile return.
5. Markowitz proposes that every level of risk has an optimal allocation to maximize the return. MPT calculations look at the overall impact on the portfolio, not the value of the asset itself. Exchange Traded Funds (EFTs) has given investors easy means to identify diverse assets.
The issue with MPT optimal allocation is that it relies on a mean-variance calculation to determine optimization. The calculation measures risk by standard deviation, expected return, and asset correlation. The actual number of risk factors is much higher. Also, asset correlation is much less defined than it used to be.
6. The last assumption is more complex. Diversification can eliminate specific security and industry risk and that correlation matters. Diversification will minimize security and industry risk, though elimination may be a stretch. This is the “eggs in one basket” statement everyone accepts. If you want more stability in your portfolio, diversification is the way to achieve it.
But the correlation issue is less certain. Correlations are not static, they are fluid. External factors often create a trajectory for individual assets. A simple example is Novavax, a biomedical company working on a vaccine for the coronavirus. When they announced a positive response in the clinical trials, their stock shot up by 1,788%.
A less obvious example is Wayfair, an online furniture and home goods store. In March, their share price was $26.25. But as the pandemic spread, their share price has jumped by 235%. While brick and mortar retail stores withered and died, eCommerce blossomed. No correlation with the market which was dropping.
One last point. MPT is a mathematical concept. Math is logical and consistent, but people are not. One of the other issues with correlation is the assumption that investors will behave in a logical, rational way. During the huge market swings of 2020 – we have seen that is not always the case.
Is MPT still a viable tool for portfolio management? Let’s take a look at the math.
What’s the Math?
MPT determines the diversification of assets in the portfolio based on the risk tolerance of the investor. Diversification isn’t new but the MPT manages risk to return through a series of defined calculations. They calculate the asset itself and the overall impact on the portfolio.
These calculations are the reason that MPT is considered credible. The premise, according to Investopedia, is to reduce the idiosyncratic risk. Idiosyncratic risk is the inherent risk unique to individual investments. What the MPT methodology does is measure the return against the inherent risk.
The assets are calculated in a weighted sum transaction to determine the portfolio’s expected return. Each asset has an expected return. If you have 4 equally weighted assets, each is calculated at 25% of the portfolio’s return. Total the combined assets and they provide an estimate of the portfolio’s return.
[Asset 1: 5% return + Asset 2: 8% return + Asset 3: 4% return + Asset 4: 12% return = 29]
29 x 25% = 7.25% anticipated portfolio return
The overall risk for the portfolio involves a complex mathematical function. For each asset, you need a variance and six correlation values. When the asset correlations are included, the standard deviation (risk) is lower than the weighted sum.
MPT creates a measurable method of portfolio management. The calculations create the baseline for analysis and diversification. The formula lets investors see the value of various assets, but also how to adjust in the event of a correlation shift.
Because the assets and the portfolios are valuated, investors have a very clear picture of performance. Incorporating exchange trading funds (EFTs) as assets provides some cover for market volatility. The balance between stocks, treasuries, and uncorrelated assets is key to applying the theory.
Math increases measurement. MPT improves transparency – every data point in the calculation can be charted. The goal is to minimize risk without sacrificing return. If we compare 2 portfolios that have the same anticipated return, but a difference in standard deviation. Risk-averse investors apply MPT to build the portfolio with the lowest risk level.
A standard complaint about MPT is the use of median variance and standard deviation. Most analysts prefer to use downside risk to estimate how risk affects a portfolio.
Downside risk estimates the decline in value of a security if there is a change in market conditions. Downside risk is a one-side test. It doesn’t look for a best-case scenario. Downside risks estimates the worst-case scenario for an investment. It quantifies the amount a loss could cost the investor.
It also looks at the reasons behind the loss, which is where it deviates from MPT.
In MPT, portfolios with the same risk level are ranked equally. If the standard deviation is the same, there’s no analysis of the risk behind it. Downside risk looks at the reasons for the ranking. The risk perspective on a portfolio should be the most manageable. A portfolio that goes through a series of small losses is much easier to endure than getting caught a single catastrophic downturn.
Applying Modern Portfolio Theory
If you choose to apply MPT, some considerations need review. Though the theory can’t be discounted, there have been many changes in how the markets function since it’s inception.
You can consistently overcome the conditions of the market.
The idea that the market always operates efficiently is out of date. The market moves at light speed. Shares prices change, and valuations are not always accurate. Modern investment systems and technology could not have been anticipated in 1952.
Past trends are not always strong indicators of current behavior.
A major stumbling block of MPT is the assumption that correlations are static. That implies what has happened in the past can be an accurate indicator of what is happening in the present. This is misleading at best. All the new asset types can’t be factored into the past trends. Though patterns can be evaluated, they should not be sacrosanct.
Investors do not always behave in a rational manner.
The two extremes – risk-averse and risk loving – provoke market reactions that have little to do with logic. Potential, much less actual, financial loss causes an emotional response. MPT is a theory, not a guarantee, but that line has blurred through the years. No portfolio management tactic is anything more than a tool. Investors should continue to vet individual assets before making decisions.
Fees and commissions are not incorporated in projected returns.
The valuations in MPT do not account for any differences between passive and actively managed accounts. Actively managed portfolios can come with a hefty price tag, up to 1.5% a year. If your estimated portfolio value is 7.25%, it dropped to 5.75%. There’s no guarantee there won’t be additional transaction fees. You can reduce those costs by investing in index funds. Remember to manage your expectations on anticipated return.
Is Modern Portfolio Theory Still Modern?
Some what but that doesn’t mean you can’t make use of it. Like any other tool for managing your investment portfolio, MPT can be helpful. What you don’t want to do is accept it as gospel. It will be 70 years old in two months.
At least half of today’s investors weren’t even born when the theory was published. The idea that it might need tweaking isn’t uncommon.
If the goal is to control risk, portfolio diversification the accepted view of the financial industry. If you want clarity between two portfolios with the same risk ratio – run a downside risk analysis on both. JThat extra bit of information may help you avoid unforeseeable losses.
Your portfolio is your money to lose. Vet the assets you’re considering. Don’t blindly go along based on a theory. (No matter how good it is.) This is true for active or passive account management. There are so many tools online to help you assess the market – here are 5 of the best.
In case you missed it, Modern Portfolio Theory was updated in 1991 by two software developers. It’s built on the principles of MPT but deviates in how it measures risk. Post Modern Portfolio Theory relies on downside risk as opposed to standard deviation.
Post Modern Portfolio Theory published a paper in 1993. Since that time it has gotten favorable reviews in the industy. Now risk-averse investors can have their analysis both ways.
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