Modern Portfolio Theory

Why Investors Decline Modern Portfolio Theory

There is no doubt that any investor would ideally choose a portfolio which would give him high returns and put him through low risk. However, the investment world and its choices are not that simple and easy. Many times, the choices have to be made under difficult circumstances. But there are quite a few portfolio management tools and theories that can come to the rescue of the investor in making his choices. In this paper we will be discussing about one of prominent theories in this aspect. We would also try why many investors do not invest according to the theory. The portfolio management theory that is being discussed in this paper is the modern portfolio theory.

Modern Portfolio Theory was first introduced to the financial world by future Nobel laureate, Harry Markowitz through his research paper in 1952. In 1959 Markowitz also wrote a book, Portfolio Selection, based on the same. He used mathematics to explain the relationship of risk to return as it relates to asset allocation. It was agreed that in cases where high returns were expected, the risk factor associated with it was also very high. However, he proved that asset classes acted differently during a market cycle. The paper also discussed how an investor can construct an investment portfolio based on his risk tolerance levels and expectation for returns (Omisore and Yusuf et al. 2012, pp. 19-28).

To put it in simpler words, stocks are generally associated with high risk and high returns. And hence if an investor buys more stocks, he might be exposing himself to too much risk. On the other hand, bonds are known for moderate returns and lower risk. Hence, according to modern portfolio theory, if an investor opts for a combination of stocks and bonds, his chances of getting a reasonable return while handling a relatively lower level of risk, increases. In short this theory for portfolio management encourages asset diversification.

Modern Portfolio Theory
Modern Portfolio Theory

However, recent studies have shown that most of times the investor does not take his investment decisions as per modern portfolio theory. This observation is made on the basis that though the benefits of diversification have increased in the recent years, considering the mean–variance portfolio theory, it is surprising to see that the level of diversification in investor portfolios has not increased accordingly. While the level of diversification exceeds much more than 300 stocks, the actual number of stocks that the investor holds remains just 3-4 (Statman 2004, pp. 44-52).

Management of Risk and Return

Many critics of modern portfolio theory would point out that this method of choosing the right investment path has ignored the part played by analysis of market and its trends. And this is also one of the key reasons that the investors cite to avoid much diversification of their assets. They believe that risk can be managed with the help of right knowledge and trading skills. This makes many to invest in high risk assets with the hope of getting more returns. They remain under the impression that in case a bear a market happens they will be quick to realize it and would sell off their high risk assets at a reasonable price. At times they also choose other alternatives to reduce the risk factor such as delegation of authority or decision delay, making them feel that they have taken a well calculated risk. And amidst all these they miss out on the diversification of their assets as they consider having solid information about a few firms better than opting for diversification (Werner F.M. De Bondt 1998, pp. 831-844).

Trading Practices

Though investors and traders try to put in practice a variety of rules and techniques, to keep their emotions at bay and let their reasons speak while making investment decisions, most of the time trading happens out of impulse. They end up buying or selling their assets without prior planning or by listening to some random suggestions made by an acquaintance (Werner F.M. De Bondt 1998, pp. 831-844).

It is also interesting to see how investors decide upon buying shares in a bull market and selling them off in a bear market. In some of the cases even the experts, who are known for taking decision in the most rational way, based upon accurate models, at times find themselves going after the crowd mentality.

Misunderstanding Modern Portfolio Theory

One another reason for many investors for not choosing the modern portfolio theory way of investing is that they confuse it with ‘buy and hold’ strategy which is done with the intention of reaping good returns in the long run. However, this is not the case with the modern portfolio theory. Though it may resemble with the ‘buy and hold’ manner of investing, as an investor who opts for modern portfolio theory will remain fully invested, it is misleading to say that the assets will remain unmanaged. As mentioned earlier, a rebalancing of holdings is always needed in accordance to mean–variance portfolio theory. This would mean that the total assets need to rebalance either quarterly or annually to keep them in line with their original portfolio percentages (Hudson Wealth Management LLC 2013).

Conclusion

It is understood that the basic fact of investing is that the investors are rewarded for taking high risks. However, not all risk is rewarded. Further, in the current economic scenario, there are not many who can really afford to take a hit. In cases for investors who hold on to a high number of high risk and highly rewarding assets are also at a greater of risk of facing a financial crisis. Hence, it is better to go with a disciplined modern portfolio theory approach of diversification which has been theoretically and practically proven for the last 60 years and have proven the ability to maximize the returns and minimize risks.

References

Omisore, I., Yusuf, M. and Christopher, N. 2012. The modern portfolio theory as an investment decision tool. Journal of Accounting and Taxation, 4 (2), pp. 19-28.

Statman, M. 2004. The Diversification Puzzle. Financial Analysts Journal, 60 (4), pp. 44-52.

Werner F.M. De Bondt. 1998. A Portrait of the Individual Investor. European Economic Review, 42 pp. 831-844.

Hudson Wealth Management LLC. 2013. What Is Modern Portfolio Theory and is it Still Effective?

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Steve Jones

My name is Steve Jones and I’m the creator and administrator of the dissertation topics blog. I’m a senior writer at study-aids.co.uk and hold a BA (hons) Business degree and MBA, I live in Birmingham (just moved here from London), I’m a keen writer, always glued to a book and have an interest in economics theory.

2 thoughts on “Modern Portfolio Theory”

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