It’s easy to sound like an investment educator maligning Modern Portfolio Theory (MPT) and belittling Chartered Financial Analysts (CFA) not to mention the implied put down of those who’ve earned an MBA. This could be taken wrong by young men and women considering an education in finance.
I’ve lost money in the past (along with many others) inappropriately applying MPT. I can agree that many investors have been hurt by the way most advisors in the investment industry incorrectly apply the principles of MPT. ERISA and the Prudent Investors Act, in effect, even mandate this incorrect application of MPT’s principles. But, the problem isn’t with MPT or education.
A quick review of the basic tenets of MPT begs the question: Which of the principles derived from MPT are no longer relevant?
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 (risk adjusted) asset allocation portfolios. But MVO was not intended to be used for managing portfolios, and it should not be considered equivalent to MPT.
Understanding the weaknesses in how MPT is applied enables investors to improve the risk-adjusted returns that their portfolio achieves from asset allocation.
What is needed is a re-thinking of how to apply the principles of MPT.
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