Has Modern Portfolio Theory Fallen into Decline? A Model Limitations Review

It has been long time since Harry Markowitz propounded his well-known theory on portfolio selection in 1952 from Rand Corporation. Dozens of academics have developed his model and criticised its limitations over the years.

Nowadays, it can be perceived in the economic literature a heavy stream which suggests that Modern Portfolio theory has been substituted by other alternative methods due to its broadly negative evaluation received over the years by researchers.

The claims are based on a number of burdens that limit the effectiveness of the Markowitz Portfolio theory. Empirical evidence shows systematic problems with the model assumptions underlying the theory that distort the quality of the model predictions. How well the theory assumptions hold the quality of these predictions? Here there are a part of the main criticised assumptions:

Investors centre decisions solely on expected return and risk –measured by the mean and variance of the historical returns on assets, which is the traditional expected returns-variance of returns rule (E-V) propounded by Markowitz. This decision strategy involves a drawback as optimal asset allocations are highly sensitive to small changes in the inputs, especially expected returns, which may lead to that portfolios are not be well diversified. Franz Fuerst (2008), at the University of Reading, proposes to conduct sensitivity tests to understand the effect on asset allocation to changes in expected returns or either to use a more robust approach to developing asset allocations –reverse optimisation.

Investors take a single-period perspective in determining their asset allocation, having the same time horizon, which leads to a drawback. Investors seldom have a single-period perspective. In a multiple-period horizon, even Treasury bills exhibit variability in returns. As Fuerst (2008) holds, including the ‘risk-free asset’ as a risky asset class can help to solve this problem.

All investors are homogenous, in the sense that they all are in agreement as to the parameters necessary, and their values (meaning that information is freely and simultaneously available to all market participants –when it is, of course not), in the investment decision making process –the means, variances and correlations of the returns on various investments.

Financial assets are arbitrary fungible. Real financial shares are usually not fungible.

It is assumed by the model three Efficient Markets Hypothesis (EMH) axioms: investors are equally informed, rational and risk-averse. It is easily observable that information asymmetry does exist and that behavioral economics research collide with the assumptions which assert that investors are rational and risk-averse. Andrei Shleifer (2000), at Harvard University, introduces an alternative view of financial markets dismantling the EMH assumptions with behavioral economics axioms and empirical evidence.

Investors can borrow and lend at the risk-free rate. It entails a drawback due to borrowing rates are always higher than lending rates. Also, certain investors are restricted from purchasing securities on margin. Fuerst (2008) proposes a potential solution by incorporating into Modern Portfolio theory differential borrowing and lending rates.

Assets’ returns are normally distributed. The mean-variance approach is well suited for application in such an environment. There are some examples of when assets’ returns do not have a normal distribution, for example when investors have a special type of utility function like hedge fund investors have, quadratic utility function. If the distribution is non-normal, the variance or the standard deviation could not be the most suitable measure of riskiness to apply on the portfolio. It has been found by researchers that returns usually have negative skew and positive excess kurtosis. Many researchers as Chris Brooks and Harry M. Kat (2002), at the University of Reading and City University of London, respectively, have performed surveys concluding that the distribution of hedge fund returns is non-normal, founding that the published hedge fund indices exhibit relatively low skewness and high kurtosis.

Investors utility function entails maximising expected return and minimising standard deviation of the return. As investors are utility maximisers, they will always swift from one investment to another which has the same expected return but less risk, or one which has the same risk but greater expected return, or one which has both of them.

There are no taxes or transaction costs. Real financial products are subject to both taxes and transaction costs.

Bearing in mind the limitations that Markowitz model can entail, fierce academic criticism can move the roots shaking the tree. In my opinion, economic models try to simplify a given reality to mathematically explain and prove the forces and interactions that share a number of given factors. It seems it is obvious that some models hold better the reality but I would say that it is not a cause of the quality of the model but of the volatility and complexity of the factors involved. Hence, it could be said that the heavy stream that reject the Markowitz model as a suitable method to produce profitable predictions just verify the complex and systematically risky environment that Markowitz model factors are submitted to.

Enrique Muñoz-Salido
Enrique Muñoz-Salido
Enrique works in the tech industry, computer software, in the City, London. His interests lie at crossroads of human behavior and software. Enrique is an Oxford Masters graduate, Talentia scholarship.