Blog 3

Is Modern Portfolio Theory still relevant?

Creating the ‘perfect investment’ consisting of low risk and high reward is something many, if not all, investors aspire to achieve. Even though there have been theories, methods and strategies to achieve this, including the popular and influential portfolio theory, in reality the desired outcome is far from what is achieved. 

The idea of portfolio theory which was developed by Harry Markowitz in 1952, is that in order to reduce risk, investors should spread their investments across a range of assets so if there was bad news concerning one company, the investor will be compensated for, by some extent from good news of another company, according to Arnold. For example, if company A is an umbrella shop and company B is a sunglasses shop, because of the frequent changes in weather, it is likely that when one company performs well the other will not, but this still lessens the volatility than if an investor was to invest into only one of these companies. 

So a question asked by many intrigued investors would be something along the lines of ‘how exactly does one create a portfolio that would give the optimal results?’ Well as return is strongly linked with risk, it is important to understand what types of risk there are. In modern portfolio theory, there are two types: Systematic risk and Unsystematic risk. The former refers to risks that cannot be helped or avoided i.e. cannot be diversified away, for example interest rates and recessions, whereas the latter, also known as specific risk, refers to risk which can be diversified away through diversification. Understanding and knowing the risks is important as to be able to mitigate them when choosing securities, helping the investor to choose the optimal portfolio. 

The efficient frontier is then used to identify the combination of securities which will produce the best outcome. Below is an illustration of the efficient frontier curve, where the less risk is taken, the lower the expected return would be and in contrast the higher the risk taken, the higher the expected return would be. The dots nearest to the curve show the optimal combinations of securities, so these are the ones which investors will be interested in, whereas the dots furthest away represent portfolios which will either offer the same returns with more risk or less return for the same risk.

One problem with modern portfolio theory is that it uses past information to help predict future trends, which is not necessarily an accurate or reliable method. Whilst past information may be used as a guide for some investors, the end results could be entirely different. For those investors who have had successful portfolios, it could just be seen as luck rather than strategy, because otherwise they would all be consistently successful and the drawbacks wouldn’t be so apparent.

Another major issue of this theory is that during financial crisis, the use of modern portfolio theory has not been able to withstand such stock-market changing events. The correlations amongst asset classes were inconsistent and unsymmetrical, so in other words the theory failed to deliver in such circumstances and from these experiences, it has called to question the usefulness of portfolio theory.

At the end of the day, modern portfolio theory is exactly that-a theory, which may sound promising to investors. However, in reality, there are many limitations of using this theory, one reason being it is difficult to predict stock market movements from past information. It also causes problems when there is no actual answer to the question ‘how much is enough?’ in relation to how many stocks you should have in your portfolio, as research and answers have been given by various people, but they are not the same. This is just other issue of using portfolio theory, but it would also bring to question, if not portfolio theory, then what? No doubt, investors are looking for a solution which will fix the problems of portfolio theory, or perhaps researching new methods and strategies altogether.