WealthThought2

Understanding a key limitation to Modern Portfolio Theory.

When Harry Markowitz introduced his Modern Portfolio Theory in 1952, it revolutionized portfolio design forever. MPT explores the concept of maximizing portfolio return for a given level of risk. The theory is as relevant today as it was in 1952. A deep understanding of its elements requires a strong competency of various statistical mathematical principles. One of the key metrics often used when Portfolio Managers discuss the efficiency of their design reveals a limitation of the theory itself.

Standard Deviation is used to measure the expected volatility of a given portfolio. MPT assumes that rational investors should prefer the portfolio with the lowest standard deviation and the solution with the tightest range of variance versus the one with the widest swings in performance. Here is where it gets a bit tricky. MPT also assumes that investors have quadratic utility which means that they have an equal preference for the upside range of the standard deviation as they do to the downside range of the standard deviation. Equal preference for negative returns and positive returns is not rational. Investors will tell you that they have a much greater preference for the upside range then they do for the downside range. I will discuss this bi-linear utility in future WealthThoughts.

In spite of this limitation, MPT remains the core framework for portfolio design in the modern era. We will continue to study how mathematicians improve the application of this time tested theory.