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Disadvantages of Modern Portfolio Theory

This paper seeks to logically discuss and critique the modern portfolio theory (MTP) that emerged in the 1950s as the brain child theory of Harry Markowitz who spearheaded its advocacy as being the first scientific means to quantify investment risks. What was meant by this was that if the concept of risk as we know it is quantified theoretically, it translates to reduced investment risk and the risk could be diversified. To most investment managers, Markowitzs theory offered a scientific means of obtaining high returns. According to most investment managers this was groundbreaking as there were no defined means of defining, understanding and quantifying investment risks. This forms the biggest impediment in investment even in modern day, but the theory offered a means for investment managers to reduce investment risk. This resulted in a whole generation of investment managers and analyst being trained based on this theory. Private Banks, asset managers and brokerage houses adopted this model and popularized it (Resnik, 2010).

Over the years, critics of the theory have opposed its application terming it virtually impossible to quantify investment risk as there are a lot of variables, both direct and indirect, that affect all spheres of investments such as equities, cash investment, securities and hedge funds. Critics were proved right when the credit crisis hit America. The investments made under the MTP theory were worse hit by the economic recession.

The MTP model was designed in a manner that allowed investors to divide assets in classes and focus their attention to a certain class of assets that was known historically to offer returns that did not correlate. However, this changed when the crisis began. For instance equities were now categorized by those companies that offered equities in relation to their market capitalization. This was in contrast with other investors especially those who had ignored the theorys investment model such as Warren Buffett and George Soros had an outstanding performance as their investments remained profitable resulting to substantial gains in their portfolios (Resnik, 2010). The reason behind their success was that they made huge bets on future performance of narrow assets class and also invested in operating companies that were based on franchise consumer goods and keeping those investments for a longer span of time.

The other aspect of the MTP theory that made most investment managers fail was the fact that MTP made investor managers believe that investing in hedge funds, private equity funds and managed future portfolios was safe and reduced their overall risk portfolio based on their turn over history. This did not happen because some of the asset classes were deemed to be non-correlating. For these investment managers to make substantive income, it required that they be in operation for quite some time. This contradicted most of these companies as they had only been operational for a short period and based of the high competition and skewness, their level of survival in the market was very low.

Lastly, some of the assumptions that were proposed by the MTP were not very substantive. For instance the theory presumed that in dividing the assets in classes every return on asset investment was normally distributed, it presumed that correlation among asset classes was fixed and thus unchangeable in time, this does not happen in a real market economy

Reference

Resnik, B. (2010). Did Modern Portfolio Theory Fail Investors in the Credit Crisis? The CPA journal. Pp. 9-13.

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