Problems with Modern Portfolio Theory
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Modern Portfolio Theory is about diversification: combining multiple investments (stocks or bonds) that zigs with another that zags, and possibly a third that zogs. Believers in MPT investing believe that diversification is your very best friend.
Modern Portfolio Theory is the key to maximizing return with minimal risk. What the theory says is that if you combine different asset classes that zig and zag (and possibly zog) in a portfolio, even though each asset class by itself may be quite volatile, the volatility of the entire portfolio can be quite low.
In fact, in some cases, you can add a volatile investment to a portfolio and, as long as that investment shows little correlation to everything else, you may actually lessen the volatility of the entire portfolio!
TRANSLATE THEORY INTO REALITY
Correlation is measured on a scale of –1 to 1. Two investments with a correlation of 1 are perfectly correlated: They move up and down in synch, like two Rockettes. Two investments with a correlation of –1 have perfect negative correlation: When one goes up, the other goes down, like pistons.
A correlation of zero means that there is no correlation between two investments: When one goes up, the other may go up or down; there’s simply no predicting, so is better to try options where you can make money like the fastpay casino online.
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In the real world, negative correlations of two productive investments are hard to find, but you can find investments that have close to zero correlation. Perhaps the best example from history is stocks and bonds.
Bonds as a whole generally move up and down independent of stock prices. Some bonds — such as long-term Treasuries — tend to have negative correlation to stocks, generally climbing during times of recession (often in response to dropping interest rates in combination with stock-investor panic that drives up demand for security).
But other bonds, such as U.S. high-yield bonds, tend to move more in synch with the stock market.
PROBLEMS WITH MODERN PORTFOLIO THEORY
- Ever-increasing globalization of economic activity and capital markets has made the major international stock markets — including the US stock market — much more positively correlated –> reducing the benefits of diversification across the markets, especially during the crisis periods (i.e. global crisis of 2008 and Brexit). All asset classes are much more highly correlated, defeating the purpose of modern portfolio theory.
- Modern portfolio theory focuses on diversifying your risk away. Academics believe that diversification always reduces risk—and because of this, diversification is often described as the only free lunch in finance. And Wall Street has bought in the academics’ concept hook-line-and-sinker. But the recent global crises has shown the limits of the approach. The concept of risk diversification is okay in normal times, but not during times of extreme market moves.
- Modern portfolio theory is a mathematical framework for assembling a portfolio of assets such that the expected return is maximized for a given level of risk. Academics views the stock market as a statistical model of financial markets. The problem is that the statistical models of the financial market don’t match the real world.