The investment landscape has seen some major changes in the last two decades. Financial and technology companies came and went, stock market values soared, plummeted and rebounded, housing derivatives blew up, and other foundations were laid bare. Even the bedrock of investing theories related to portfolios has come under duress. Yet the belief in Modern Portfolio Theory has remained robust amongst the investing public. Should it?

A basic understanding of Modern Portfolio Theory is helpful. According to the recent Dalbar study we’ve referenced before, Modern Portfolio Theory (MPT)…

“Is grounded in the observation that asset classes are predictably uncorrelated. MPT is based on the theory that risk can be mitigated by diversifying into uncorrelated asset classes. However, unless the correlations of the various asset classes are predictable, the mitigation of risk is lost.

Investors expect to be rewarded for the level of risk they are taking in a particular market. Investment results in 2008 showed clearly that correlation of asset classes varied unpredictably and with no warning. This brings into question the very basis for MPT and its ability to forecast an efficient frontier.”

Modern Portfolio Theory is almost 60 years old. In a 1952 paper and 1959 book, Portfolio Selection, future Nobel laureate Harry Markowitz expounded MPT for the investment world. Markowitz used mathematics to explain the relationship of risk to return as it relates to asset allocation. He agreed that higher expected returns necessarily increased the risk in a portfolio. However, he proved that asset classes acted differently during a market cycle and discussed how portfolios can be constructed to match investor risk tolerance and expected returns.

In its short history, MPT has come under question from various directions. For one, MPT assumes that investors are always rational and risk-averse. While Markowitz and other PhDs in Economics may fit that description, most investors do not (see behavioral finance). That’s why it’s important to match your portfolio with your appropriate risk profile. You must also modify your risk appetite as you and your portfolio grow older and circumstances change.

Second, MPT assumes all investors have access to the same information at the same time. This simply isn’t right. Even if you watch CNBC while the market is open and troll the blogs during the rest of your waking hours, you won’t have the same information in the same timely manner as many professionals. This can be a huge missing piece to your strategic investment puzzle.

Another assumption of MPT is that investors accurately understand what returns are possible. This is often not the case and is why many investors often need help from money managers. Professionals are more likely to understand real-world limitations of Modern Portfolio Theory.
As the Dalbar study explains:

“The Achilles’ heel of MPT is that it simply cannot be reduced to a mathematical model or relied upon as the sole basis for the management of investment decisions. Instead, it should be thought of as only one reference point for modeling the behavior of a potential portfolio; it is only one dimension of a more comprehensive investment management process.”

In other words, Modern Portfolio Theory as an investment strategy is fundamentally incomplete. The markets of the last decade have provided such evidence. However, as a foundation upon which to build a strategy, it still can be of great benefit.

Whether you’re working with a money manager or constructing your own portfolios, it’s important to understand the appropriate risk/return relationship. In addition, it is worthwhile to address how various asset classes affect the risk and return of your portfolio over time. Going all in on “short Thailand” may work once, but it’s hardly a long-term investing strategy.