Many investment advisers, financial planners, and others build their strategies around what is known as Modern Portfolio Theory (MPT).
A basic understanding of MPT can be helpful to you, since your retirement plan, and other investing efforts are likely based, to some degree, around MPT.
Overview of MPT
The main idea behind MPT is to use its principles to construct a portfolio that maximizes returns for a certain level of risk. Asset allocation is a major part of the picture, since it is used to help to meet the goals of the investor.
Many of those involved with the development of MPT (which took place largely in the 1950s through the early 1970s) have received Nobel prizes, and there has been a lot of interest in using MPT to help create a portfolio. MPT is especially popular when it comes to DIY investing, since the asset allocation aspect makes it relatively easy for the individual investor to create his or her own portfolio based on the the concept of proper asset diversification for a certain risk tolerance.
MPT is based on mathematical calculations, even though many investors and investment planners have managed to simplify the concepts in the way they assemble portfolios.
Criticisms of MPT
Like nearly all theories — especially financial theories — there are some criticisms of MPT. First of all, there are a few assumptions that MPT makes that might not be reflected in the “real world” of investing:
- Taxes and transaction costs: Unfortunately, MPT doesn’t take into account some of the costs that come with investing. MPT doesn’t always account for the fees you pay, nor the taxes you are subject to.
- Investors access the same information: It’s a nice thought that all investors can access the same information simultaneously. Unfortunately, this is just not true. Those with access to more information, or better information, can make different choices.
- Asset correlations are constant: One of the biggest criticisms of MPT right now is the fact that the theory assumes that asset correlations will remain the same. Bonds and stocks will always react the same way to each other is one assumption. However, this might not be the case. Indeed, more and more we are seeing that correlations don’t always remain the same.
- Volatility is constant: This is another common criticism of MPT. While the theory seems to indicate that volatility can be predicted, it can’t. We’ve seen that illustrated quite well recently. Additionally, MPT assumes that markets accurately price risk, when they actually don’t.
- Investors don’t influence prices: Behavioral finance has been taking a lot of the wind out of the sails of MPT in recent years. In many versions of MPT, it is assumed that investors simply take the price, without influencing it. The theory also assumes that investors are accurate in their ideas of possible risk/return, as well as that they act rationally. We know that none of this is true. Investor sentiment can, indeed, influence prices, and often investors don’t act rationally — and that can change the course of the markets.
While there are those who make tweaks to MPT, and apply the principles reasonably well, and while MPT can make a reasonable starting point, there are increasing questions about its effectiveness in the current market — and the way it seems to be changing.
Readers: What do you think of MPT?