Improving Modern Portfolio Theory

By MBA, CFP® - Chief Executive Officer, Vernon C. Sumnicht on February 19, 2017

In an article, originally written in 2010 for “NAPFA Advisor,” iSectors CEO, Vern Sumnicht took a deeper into Modern Portfolio Theory — including its core principles and problems, and how MPT could be implemented in investing landscape that year. Seven years later, many (if not most), of the points discussed in this “classic article” still hold true today.

Improving Modern Portfolio Theory

Exceptional volatility and the lack of overall investment return during the “lost decade” have investors and their advisors touting the apparent death of modern portfolio theory (MPT). On the contrary, to paraphrase Mark Twain, “The rumors of MPT’s death have been greatly exaggerated.” A quick review of the basic tenets of MPT begs the question: Which of the principles derived from MPT are no longer relevant?

• Are investors no longer risk averse?
• Are equity and bond markets no longer fairly priced or efficient?
• Is the allocation of the portfolio, as a whole, more important than individual security selection or market timing?
• Should investors no longer invest for the long-term?
• Is there no longer an Efficient Frontier where every level of risk has an optimal allocation of asset classes that will maximize returns?
• Would investors rather be concentrated in a few asset classes than be diversified among a greater number of asset classes with low correlation to each other?

Common sense instructs most investors that these basic principles, derived from MPT, remain as relevant today as they were the day they were conceived. Most of the present confusion seems to derive from mean variance optimization (MVO); this is the asset allocation formula used to determine the efficient frontier of optimal asset allocation portfolios. But MVO was not intended to be used for managing portfolios, and it should not be considered equivalent to MPT. With advances in research and technology, academia has derived a field of study from traditional MPT known as post-modern portfolio theory. This field of study is giving legitimacy to obvious weaknesses in the way MPT is applied by investors. What follows is an outline of the weaknesses of how MPT has traditionally been applied, along with solutions to improve these weaknesses.

Read full article here.