Myths about Modern Portfolio Theory (MPT)

QuietGrowth - Myths about Modern Portfolio Theory (MPT)

When exploring the world of finance and investing, you might encounter various myths and misconceptions about Modern Portfolio Theory (MPT). So let’s debunk some of these myths.

Myth 1: MPT only works in bull markets

Fact: MPT is designed to optimise portfolios for any market condition, not just bull markets. The theory encourages diversification, which means spreading investments across various asset classes. The aim is to balance risk and return, regardless of market conditions.

However, MPT can face challenges during extreme market stress or crisis when correlations between assets can increase dramatically. This challenge does not mean that MPT fails outright. It’s important to remember that MPT provides a model — a simplification of reality — that helps guide investment decisions. Like any model, it’s not perfect, and investors should be prepared for times when market behaviour deviates from the model’s assumptions.

In a bear market, investors might shift their portfolios towards assets that are less correlated with the market, or that tend to perform well in such conditions, still using MPT principles to guide these adjustments.

Myth 2: MPT assumes all investors are the same

Fact: While MPT operates under certain assumptions about investor behaviour, it does not assume that all investors are the same. It allows for differing risk tolerances and financial goals. By assessing each individual’s risk tolerance and investment objectives, MPT helps tailor investment portfolios to each investor’s specific needs.

Myth 3: MPT guarantees maximum returns

Fact: MPT does not guarantee maximum returns; rather, it aims to maximise expected returns for a given level of risk. It’s important to remember that “expected returns” are just estimates, and actual returns may be different. Also, higher expected returns come with higher risk, which means the potential for losses is also greater.

Myth 4: MPT is only for large, institutional investors

Fact: MPT can be applied by any investor, regardless of her investment size. Diversification and risk-return optimisation are as relevant for individual investors as for large, institutional ones. While the specific investments accessible may differ between large and small investors, the fundamental concepts and benefits of MPT apply across the board. In fact, robo-advisors have made MPT-based portfolio management, influenced by MPT, accessible to individual investors on a large scale.

Myth 5: MPT assumes markets are always efficient

Fact: While MPT relies on the assumption of efficient markets for its theoretical framework, it doesn’t imply that markets are always efficient. The assumption of market efficiency is made to simplify the model, but MPT practitioners understand that markets can sometimes be inefficient. Therefore, they use this as a baseline model, adjusting their strategies to account for market inefficiencies when necessary.

Myth 6: MPT ignores the role of investor psychology

Fact: MPT assumes that investors are rational and always make decisions that maximise their expected utility. However, this doesn’t mean that the role of investor psychology is ignored. Behavioural finance studies have shown that investors often behave in ways inconsistent with strict rationality. While the original formulation of MPT may not account for psychological factors, its adaptations and implementations often consider behavioural biases. For instance, robo-advisors, influenced by MPT, may adjust their algorithms to account for common cognitive biases.

Myth 7: MPT advocates for over-diversification

Fact: While MPT strongly advocates for diversification to reduce unsystematic risk, it doesn’t imply that investors should own a maximum number of securities or asset classes. The goal is to achieve optimal diversification, where adding more securities does not significantly reduce risk further.

Myth 8: MPT encourages frequent trading

Fact: MPT is not about timing the market or making frequent trades. It is about building an optimal portfolio based on an investor’s risk tolerance and return objectives, and then periodically rebalancing the portfolio to maintain its desired risk-return characteristics. Regular rebalancing does not equate to frequent trading; it ensures the portfolio does not drift from its intended allocation over time due to market dynamics.

Myth 9: MPT is only applicable for long-term investments

Fact: The principles of diversification, the risk-return trade-off, and portfolio optimisation can benefit all investors, regardless of their investment horizon.

MPT is not inherently limited to long-term investments; it can be applied to any investment period. However, it is often associated with long-term investing because it is built on the idea of maximising return for a given level of risk over a specific investment horizon. The longer the horizon, the more time there is for the portfolio’s returns to average out, reducing the effect of short-term fluctuations or market volatility.

Another aspect of MPT is its focus on diversification to reduce risk. Diversification typically works best over the long term.

Moreover, MPT assumes that returns are normally distributed, an assumption that may hold better over longer periods. However, over short periods, market returns may exhibit skewness, kurtosis, or other deviations from normality, which could affect the performance of a portfolio constructed using MPT principles.

It is important to note that the principles of diversification, the risk-return trade-off, and portfolio optimisation can benefit all investors, regardless of their investment horizon.

In essence, while MPT can be applied to short-term investments, the theory’s assumptions and principles may align more naturally with a long-term investment horizon.

Myth 10: MPT is outdated and no longer relevant

Fact: Despite being developed in the 1950s, MPT remains a foundational theory in finance and investing. Its principles of diversification, risk-return trade-off, and portfolio optimisation continue to guide investment management strategies. That said, like any theory, it’s important to understand its assumptions and limitations and adjust its application to the changing market conditions and advancements in financial models.

Myth 11: MPT advocates for passive investing only

Fact: MPT doesn’t inherently advocate for either passive or active investing; it provides a framework for optimising a portfolio given an investor’s risk tolerance and return objectives. MPT can be used in the construction of both passive and active portfolios. For example, in a passive investing approach, MPT could guide the selection of index funds to achieve broad diversification. In contrast, in an active approach, MPT could guide the selection of a diversified mix of individual securities.

Myth 12: MPT assumes that investors have unlimited access to borrowing and lending

Fact: While the original formulation of MPT does assume that investors can lend and borrow at the risk-free rate without limits, this is a simplifying assumption made to develop the theory. In practice, these assumptions are not realistic, and practitioners of MPT are aware of this. Therefore, they would be adjusting their application of MPT to account for real-world constraints, such as borrowing limits and interest rates that are not risk-free.

Myth 13: MPT is only about minimising risk

Fact: MPT is not solely about minimising risk; rather, it is about achieving the best possible return for a given level of risk or minimising risk for a given level of expected return. Risk and return go hand in hand, and MPT is about optimising the trade-off between the two.

Myth 14: MPT assumes that past performance predicts future results

Fact: MPT does not assume that past performance predicts future results. Instead, it uses historical data to calculate returns, risks, and correlations, which are then used to construct an optimal portfolio. MPT practitioners understand that future market conditions and asset performance may differ from historical patterns.

Myth 15: MPT neglects the importance of individual stock analysis

Fact: MPT does not negate the importance of individual stock analysis. Instead, it adds another layer to the investment decision-making process. While traditional analysis focuses on identifying undervalued or overvalued stocks, MPT considers how adding a particular stock impacts the overall portfolio’s risk and return. Thus, MPT and individual stock analysis can complement each other in a comprehensive investment strategy.

Myth 16: MPT is incompatible with value investing

Fact: While value investing and MPT approach investing from different angles, they’re not necessarily incompatible. Value investing is primarily about identifying and investing in undervalued stocks, while MPT is about building an optimal portfolio that maximises return for a given level of risk. A value investor can still use MPT principles to construct a diversified portfolio of undervalued stocks, thereby managing risk while pursuing value-based returns.

Myth 17: MPT is all about quantitative analysis and ignores qualitative factors

Fact: It’s true that MPT is a quantitative framework that uses numerical data to build optimal portfolios. Also, MPT primarily deals with quantifiable risks that can be measured in terms of volatility or standard deviation.

However, qualitative factors still need to be addressed in the investment process. Qualitative factors, such as the quality of a company’s management, competitive positioning, or regulatory environment, can influence the expected return and risk of a security and can be factored into the MPT analysis.

Non-quantifiable risks, such as political risk or regulatory risk, are more challenging to incorporate into the MPT framework. However, investors can factor in these risks by adjusting their expectations of returns for relevant assets or by including assets in their portfolio that tend to perform well under specific risk scenarios.

Myth 18: MPT assumes markets are always efficient

Fact: MPT does not explicitly assume that markets are always efficient. While it’s true that the efficient market hypothesis (EMH) and MPT are often discussed together in traditional financial theory, MPT focuses more on the relationship between risk and return in a diversified portfolio. MPT can be applied regardless of whether markets are perfectly efficient, although its assumptions about risk, return, and diversification might hold more accurately in more efficient markets.

Myth 19: MPT is too complex for the average investor to understand

Fact: While MPT involves some advanced concepts and can be mathematically intensive, the fundamental principles are intuitive: don’t put all your eggs in one basket (diversification), and balance the trade-off between risk and return. Even without delving into the mathematical details, these principles can guide the average investor in making smarter investment decisions.

Myth 20: MPT ignores the role of luck in investment success

Fact: MPT does not ignore the role of luck. Instead, it provides a systematic framework for making investment decisions, reducing the reliance on luck. By diversifying and optimising the risk-return trade-off, MPT aims to maximise the probability of achieving a certain level of return for a given risk rather than relying on the luck of picking a few winning stocks.

Myth 21: MPT Is only applicable for equity investments

Fact: MPT is not just for equities. MPT can be applied to any asset class, including bonds, commodities, real estate, and alternative investments. When constructing the portfolio, the key is to consider the expected returns, risks, and correlations of all these different assets. In fact, including different types of assets can enhance diversification and improve the portfolio’s risk-return dynamic.

Related information

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