¶ … Theory (MPT) and its role in asset allocation and diversification. The paper reviews arguments in favor of and against MPT, in addition to reviewing how MPT affects portfolio management. MPT describes a theory on how risk-averse investors can build portfolios that optimize or maximize expected return based on a given level of market risk, while emphasizing that risk is an inherent factor of higher reward. MPT posits that it is possible to construct an "efficient frontier" of optimal portfolios that offer the maximum possible expected return for a given level of risk (Modern portfolio theory, 2011).

Modern Portfolio Theory

Typically, an investor looking for the ideal investment, would choose one whose attributes included high returns coupled with low risk. The ideal investment probably does not exist, but the search for it has caused financial managers and investment analysts to spend time to develop methods and strategies, many of which are based on MPT.

Developed by Harry Markowitz and published under the title "Portfolio Selection" in the 1952 Journal of Finance, MPT remains one of the most important and influential economic theories dealing with finance and investment. MPT argues that it is not enough to look at the expected risk and return of a particular stock, but rather, the theory posits that by investing in more than one stock, the investor benefits from diversification, and thereby reduces the riskiness of the portfolio (McClure, 2011).

In most investment scenarios, the risk that investors take when they buy a stock is that the return will be lower than expected, that is, the stock deviates from the average return. Each stock is characterized by its own standard deviation from the mean, which MPT terms risk. Markowitz uses MPT to demonstrate that the risk in a portfolio that contains diverse individual stocks will be less than the risk inherent in holding any one of the individual stocks (assuming the risks of the various stocks are not directly related.) Markowitz showed that successful investing requires more than selecting stocks, that it requires choosing the correct combination of stocks (Ibid).

MPT holds that there are two components of risk that accompany individual stock returns. MPT defines systematic risk, such as interest rates, recessions, and war, as market risks that cannot be diversified away; while unsystematic risk is defined as risk that is specific to individual stocks and can be diversified away as one increases the number of stocks in a portfolio. This specific risk represents the component of a stock's return that is not correlated with general market moves. For a well-diversified portfolio, risk or average deviation from the mean of each stock does not contribute much to portfolio risk. Rather, it is the difference or covariance between individual stocks' levels of risk that determines the overall level of portfolio risk. Consequently, investors benefit from holding diversified portfolios as opposed to individual stocks (Ibid).

Given the benefits of diversification, the investor must be able to identify the ideal level of diversification. The investor can use the existence of efficient frontier to identify the best level of diversification to establish risk measures. There is one portfolio that offers the lowest possible risk for every level of return. Likewise for every level of risk, there is a portfolio that offers the highest return. These combinations of risk and return can be plotted on a graph to produce a line that defines what is known as the efficient frontier, as shown in the graph below in Figure 1. It shows the efficient frontier for two stocks, a high risk/high return technology stock, Google, and a low risk/low return consumer products stock, Coca Cola (Ibid).

Figure 1

Any portfolio that lies on the upper part of the curve is efficient, and yields the maximum expected return for a given level of risk. The rational investor holds a portfolio only if it lies somewhere on the efficient frontier (Ibid).

MPT advances this idea even further. The portfolio theory suggests that by combining a stock portfolio that sits on the efficient frontier with a risk-free asset, which purchase is funded by borrowing, actually increases returns beyond the efficient frontier. That is, if the investor borrows to acquire a risk-free stock, then the remaining stock portfolio can have a riskier profile, and therefore, a higher return than one might otherwise choose (McClure 2011).

MPT has had a pronounced impact on how investors perceive risk, return, and portfolio management. The theory shows that portfolio diversification can reduce investment risk, and as a result, modern money managers routinely follow its principles.

In spite of...

One such shortcoming is that it frequently requires investors to rethink notions of risk. In some circumstances, it requires that the investor take on a perceived risky investment -- futures, for example - in order to reduce overall risk; a challenging concept for an investor not familiar with the benefits of sophisticated portfolio management techniques (Ibid).
Similarly, while it may be logical to borrow to hold a risk-free asset to increase one's portfolio returns, finding a truly risk-free asset is not an easy task. Even though government-backed bonds are presumed to be risk-free, in reality they are not. Securities such as gilts (risk-free bonds issued by the British government) and U.S. treasury bonds are free of default risk, but expectations of rising inflation and interest changes can both affect their value.

Indeed, there is also the basic question of what number of stocks is required for diversification as defined by MPT; just how many is enough? McClure (2011) in his article maintains that investment guru William J. Bernstein says that even 100 stocks are not enough to diversify away unsystematic risk; whereas according to McClure, Edwin J. Elton and Martin J. Gruber, in their book "Modern Portfolio Theory And Investment Analysis" (1981) conclude that an investor would come very close to achieving optimal diversity after adding the twentieth stock (Ibid).

Additional criticism of MPT centers around one of its key concepts, that of beta, which is a measure of how much a financial instrument, such as a stock, changes in price relative to its market. Beta is considered to be a measure of investment riskiness, such that the higher the absolute value of beta, the riskier the investment. Modern MPT constructs portfolios by mixing stocks with different positive and negative betas to produce a portfolio with minimal beta for the group of stocks taken as a whole. A significant objection to the concept of beta is that while it is possible to measure the historical beta for an investment, it is not possible to know what its beta will be going forward (What is Modern Portfolio Theory?, 2011).

MPT also assumes that it is possible to select investments whose performance is independent of the other assets in the portfolio. But market historians have shown that there are no such instruments because in times of market stress, seemingly independent investments do, in fact, behave as though they are related (Ibid).

Warner points out some of MPT's shortcomings in her article "Rethinking Modern Portfolio Theory" (2010), arguing that "…more and more practitioners believe the theory doesn't deal adequately with today's world." Warner argues that according to MPT, stock market crashes like those of 1987, 2000, and 2008 are supposed to be outlier events, happening so rarely that a diversified portfolio with a long time horizon can survive and recover. Warner also discusses a widespread criticism of MPT, that it treats both upside and downside volatility as risk; however investors don't experience upside volatility as risky at all. As Evensky puts it, "Investors aren't risk-averse, they're loss-averse."

Morien (n.d.) criticizes MPT for its reliance on the assumption that investors are rational and risk-averse, that they are completely aware of all risk entailed in an investment, that they will take positions based on a determination of risk and consequently demand a higher return for accepting greater volatility. Rather, as Morien points out, "Three hundred years of Tulipomania, South Seas bubbles, real estate rushes, gold rushes, concept stocks, junk bond busts, dot coms, and Asian crises have shown that politics and psychology have a major effect on markets" (Ibid).

Portfolio diversification among various asset categories is the goal of MPT. With respect to MPT and other asset categories, it may be more challenging to map mutual funds to the asset class definitions of MPT than one might think. Bond funds, that is, mutual funds that invest in bonds rather than stocks, behave more like the stock asset class than the bond asset class. Since the early 1960s, the volatility of bonds has grown in relation to stocks, which contradicts the expectations of MPT (Modern portfolio theory and mutual funds, 2011).

MPT plays a role in portfolio management for the asset category of options or managed futures. As Vision Financial Markets notes, one of the most uncorrelated and independent investments vs. stocks are professionally managed futures. Their article quotes Lintner in his 1983 landmark study "the combined portfolio of stocks (or stocks and bonds) after including judicious investments & #8230; in leveraged managed futures accounts show substantially…