Journal of Accounting and Taxation Vol. 4(2), pp.

19-28, March 2012

Available online at http://www.academicjournals.org/JAT
DOI: 10.5897/JAT11.036
ISSN 2141-6664 ©2012 Academic Journals

Review

The modern portfolio theory as an investment decision

tool
Iyiola Omisore1, Munirat Yusuf 2* and Nwufo Christopher .I.3
1
Senator, Federal Republic of Nigeria.
2
Department of Business Administration, University of Abuja, Abuja, Nigeria.
3
Department of Accounting, University of Abuja, Abuja, Nigeria.
Accepted 13 February, 2012

This research paper is academic exposition into the modern portfolio theory (MPT) written with a
primary objective of showing how it aids an investor to classify, estimate, and control both the kind and
the amount of expected risk and return in an attempt to maximize portfolio expected return for a given
amount of portfolio risk, or equivalently minimize risk for a given level of expected return. A
methodology section is included which examined applicability of the theory to real time investment
decisions relative to assumptions of the MPT. A fair critique of the MPT is carried out to determine
inherent flaws of the theory while attempting to proffer areas of further improvement (for example, the
post-modern portfolio theory [PMPT]). The paper is summarised to give a compressed view of the
discourse upon which conclusions were drawn while referencing cited literature as employed in the
course of the presentation.

Key words: Assets, beta coefficient, diversification, expected returns, investment, portfolio, risk, uncertainty.

INTRODUCTION

This paper presentation is an assessment of the modern knowledge to understanding the workings of the financial
portfolio theory as an investment decision tool. In the market. Despite the span of the research, specific
investment world, there exist different motives for invest- attention would be accorded to the Modern Portfolio
ment. The most prominent among all is to earn a return Theory.
on investment. However, selecting investments on the In the course of this discourse, some historical
basis of returns alone is not sufficient. The fact that most background to financial market analysis would be
investors invest their funds in more than one security examined, related literature (to Modern Portfolio Theory)
suggests that there are other factors, besides return, and reviewed, its applications, pros and cons of the theory
they must be considered. The investors not only like would equally be examined.
return but also dislike risk. It is intended that this write-up would add to the existing
The financial market, despite the benefits and rewards, pool of knowledge on the concept being investigated.
is a complexly volatile industry which requires critical
analysis to adequately evaluate risks relative to returns to
aid decisions as regards participation in the industry. LITERATURE REVIEW
Upon such premise, this research work is an academic
insight into some analytics of the financial market. The Investment portfolio theories guide the way an individual
presentation is an attempt to create foundation investor or financial planner allocates money and other
capital assets within an investing portfolio. An investing
portfolio has long-term goals independent of a market's
day-to-day fluctuations; because of these goals,
*Corresponding author. E-mail: [email protected]. investment portfolio theories aim to aid investors or
20 J. Account. Taxation

financial planners with tools to estimate the expected risk Where withal to back up their opinions; these two
and return associated with investments. concepts are called psych (psychology) and supply/
Passive portfolio theories, on one hand, combine an demand.
investor's goals and temperament with financial actions. Technical analysts use market indicators of many sorts,
Passive theories propose minimal input from the investor; some of which are mathematical transformations of price,
instead, passive strategies rely on diversification, buying often including up and down volume, advance/decline
many stocks in the same industry or market, to match the data and other inputs. These indicators are used to help
performance of a market index. Passive theories use assess whether an asset is trending, and if it is, the
market data and other available information to forecast probability of its direction and of continuation. Also,
investment performance. relationships between price/volume indices and market
Active Portfolio Theories come in three varieties. Active indicators are sought. Examples include the relative
portfolios can either be patient, aggressive or conser- strength index, and MACD. Other avenues of study
vative. Patient portfolios invest in established, stable include correlations between changes in options (implied
companies that pay dividends and earn revenue despite volatility) and put/call ratios with price. Also, important are
economic conditions. Aggressive portfolios buy riskier sentiment indicators such as put/call ratios, bull/bear
stocks, those that are growing, in an attempt to maximize ratios, short interest, implied volatility, etc.
returns; because of the volatility to which this type of There are many techniques in technical analysis.
portfolio is exposed, it has a high turnover rate. As the Adherents of different techniques (for example,
name implies, conservative portfolios invest with an eye Candlestick charting, Dow Theory, and Elliott Wave
on yield and long-term stability. theory), may ignore other approaches, yet many financial
In any financial market analysis, if the objective of the traders combine elements from more than one technique.
analysis involves determination of stocks to buy and at Some technical analysts use subjective judgment to
what price, there are two basic methodologies: decide which pattern(s) a particular instrument reflects at
Fundamental analysis, which maintains that markets may a given time and what the interpretation of that pattern
misprice a security in the short run but that the "correct" should be. Others employ a strictly mechanical or
price will eventually be reached. Profits can be made by systematic approach to pattern identification and
trading the mispriced security and then waiting for the interpretation.
market to recognize its "mistake" and re-price the Technical analysis is frequently contrasted with
security. Technical analysis, maintains that all information fundamental analysis; the study of economic factors that
is reflected already in the stock price. Trends 'are your influence the way investors price financial markets.
friend' and sentiment changes predate and predict trend Technical analysis holds that prices already reflect all
changes. Investors' emotional responses to price such trends before investors are aware of them.
movements lead to recognizable price chart patterns. Uncovering those trends is what technical indicators are
Technical analysis does not care what the 'value' of a designed to do, imperfect as they may be. Fundamental
stock is. Their price predictions are only extrapolations indicators are subject to the same limitations, naturally.
from historical price patterns. Some traders use technical or fundamental analysis
Fundamental analysis of a business involves analysing exclusively, while others use both types to make trading
its financial statements and forexhealth, its management decisions.
and competitive advantages, and its competitors and
markets. When applied to futures and, it focuses on the
overall state of the economy, interest rates, production, THE MODERN PORTFOLIO THEORY (MPT)
earnings, and management.
Fundamental analysis is performed on historical and Harry Markowitz 1991, an American economist in the
present data, but with the goal of making financial 1950s developed a theory of "portfolio choice," which
forecasts. There are several possible objectives: allows investors to analyse risk relative to their expected
return. For this work Markowitz, a professor at Baruch
1. To conduct a company stock valuation and predict its College at the City University of New York, shared the
probable price evolution 1990 Nobel Memorial Prize in Economic Sciences with
2. To make a projection on its business performance William Sharpe and Merton Miller.
3. To evaluate its management and make internal Markowitz’s theory is today known as the Modern
business decisions Portfolio Theory, (MPT). The MPT is a theory of
4. To calculate its credit risk investment which attempts to maximize portfolio
expected return for a given amount of portfolio risk, or
While fundamental analysts examine earnings, dividends, equivalently minimize risk for a given level of expected
new products, research and the like, technical analysts return, by carefully choosing the proportions of various
examine what investors fear or thought of these assets. Although the MPT is widely used in practice in the
developments and whether or not investors have the financial industry, in recent years, the basic assumptions
 Omisore et al. 21

0.01

Capital Market Line (CML)

0.025

0.02

0.015

Markowitz Efficient Frontier

0.01

0.005

0
-0.02 0 0.02 0.04 0.06 0.08 0.1 0.12

Figure 1. Markouwitz Modern Portfolio theory.

of the MPT have been widely challenged. weighted combination of assets so that the return of a
The Modern Portfolio Theory, an improvement upon portfolio is the weighted combination of the assets'
traditional investment models, is an important advance in returns. By combining different assets whose returns are
the mathematical modelling of finance. The theory not perfectly positively correlated, MPT seeks to reduce
encourages asset diversification to hedge against market the total variance of the portfolio return. MPT also
risk as well as risk that is unique to a specific company. assumes that investors are rational and markets are
The theory (MPT) is a sophisticated investment efficient.
decision approach that aids an investor to classify, The fundamental concept behind the MPT is that
estimate, and control both the kind and the amount of assets in an investment portfolio should not be selected
expected risk and return; also called Portfolio individually, each on their own merits. Rather, it is
Management Theory. Essential to the portfolio theory are important to consider how each asset changes in price
its quantification of the relationship between risk and relative to how every other asset in the portfolio changes
return and the assumption that investors must be in price.
compensated for assuming risk. Portfolio theory departs Investing is a trade-off between risk and expected
from traditional security analysis in shifting emphasis return as shown in Figure 1. Generally, assets with higher
from analysing the characteristics of individual expected returns are riskier (Taleb, 2007). For a given
investments to determining the statistical relationships amount of risk, the MPT describes how to select a
among the individual securities that comprise the overall portfolio with the highest possible expected return. Or, for
portfolio (Edwin and Martins 1997). a given expected return, the MPT explains how to select
The MPT mathematically formulates the concept of a portfolio with the lowest possible risk (the targeted
diversification in investing, with the aim of selecting a expected return cannot be more than the highest-
collection of investment assets that has collectively lower returning available security, of course, unless negative
risk than any individual asset. The possibility of this can holdings of assets are possible).
be seen intuitively because different types of assets often
change in value in opposite ways. But diversification
lowers risk even if assets' returns are not negatively Concept of risk and expected return
correlated-indeed, even if they are positively correlated.
More technically, the MPT models an asset return as a Return
normally distributed function (or more generally as an
elliptically distributed random variable), define risk as the Return is the basic motivating force and the principal
standard deviation of return, and models a portfolio as a reward in any investment process. Returns may be
22 J. Account. Taxation

defined in terms of realized return (that is, the return market risk. The market risk is represented by fluctuation
which has been earned) and expected return (that is, the in the market benchmark, that is, market index. Shares
return which the investor anticipates to earn over some whose β factor is more than 1 are considered less risky. It
future investment period). The expected return is a may be noted that β is a measure of systematic risk
predicted or estimated return and may or may not occur. which cannot be diversified away.
The realized returns in the past allow an investor to The total risk of an investment consists of two
estimate cash inflows in terms of dividends, interest, components: diversifiable (unsystematic) risk and non-
bonus, capital gains, etc., available to the holder of the diversifiable (systematic) risk. The relationship between
investment. The return can be measured as the total gain total risk, diversifiable risk, and non-diversifiable risk can
or loss to the holder over a given period of time and may be expressed by the following equation:
be defined as a percentage return on the initial amount
invested. With reference to investment in equity shares, Total risk = Diversifiable risk + Non diversifiable risk
return is consisting of the dividends and the capital gain
or loss at the time of sale of these shares.
Assumptions of the modern portfolio theory

Risk The framework of the MPT makes many assumptions

about investors and markets. Some are explicit in MPT
Risk in investment analysis, is the unpredictability of equations; such as the use of Normal distributions to
future returns from an investment. The concept of risk model returns. Others are implicit, such as the neglect of
may be defined as the possibility that the actual return taxes and transaction fees. None of these assumptions
may not be same as expected. In other words, risk refers are entirely true, and each of them compromises the MPT
to the chance that the actual outcome (return) from an to some degree. Predominant among the MPT assump-
investment will differ from an expected outcome. With tions is the efficient market theory.
reference to a firm, risk may be defined as the possibility
that the actual outcome of a financial decision may not be
same as estimated. The risk may be considered as a The efficient market theory
chance of variation in return. Investments having greater
chances of variations are considered more risky than The efficient market theory is widely referred to as a
those with lesser chances of variations. hypothesis, and thus efficient market hypothesis (EMH)
Risk should be differentiated from uncertainty; Risk is asserts that financial markets are "informationally
defined as a situation where the possibility of happening efficient". That is, one cannot consistently achieve returns
or non-happening of an event can be quantified and in excess of average market returns on a risk-adjusted
measured: while uncertainty is a situation where this basis, given the information available at the time the
possibility cannot be measured. Thus, risk is a situation investment is made.
where probabilities can be assigned to an event on the There are three major versions of the MPT hypothesis:
basis of facts and figures available regarding the "weak", "semi-strong", and "strong". The weak EMH
decision. Uncertainty, on the other hand, is a situation asserts that prices of traded assets (for example, stocks,
where either the facts and figures are not available, or the bonds, or property) already reflect all past publicly
probabilities cannot be assigned. available information. The semi-strong EMH opines that
prices reflect all publicly available information and that
prices change to reflect new public information. The
Measurement of risk and the beta coefficient
strong EMH additionally claims that prices instantly reflect
No investor can predict with certainty whether the income even hidden or "insider" information. There is evidence
from an investment will increase or decrease and by how for and against the weak and semi-strong EMHs, while
much. Statistical measures can be used to make precise there is powerful evidence against the strong EMH
measurement of risk about the estimated returns, to (Andrei, 2000).
gauge the extent to which the expected return and actual Extensive researches have revealed signs of
return are likely to differ. The expected return, standard inefficiency in financial markets. Critics have blamed the
deviation and variance of outcomes can be used to belief in rational markets for much of the late-2000s
measure risk. global financial crisis. In response, proponents of the
hypothesis have stated that market efficiency does not
mean having no uncertainty about the future, rather the
Beta coefficient market efficiency is a simplification of the world which
may not always hold true, and that the market is
There is another measure of risk known as β which practically efficient for investment purposes for most
measures the risk of one security/ portfolio relative to individuals (Chambernan, 1983).
 Omisore et al. 23

Asset returns are (jointly) normally distributed expectations being biased, causing market prices to be
random variables informationally inefficient. This possibility is studied in the
field of behavioural finance, which uses psychological
Despite this assumption, evidence from frequent assumptions to provide alternatives to the capital asset
observations shows that returns in equity and other pricing model (Owen and Rabinovitch, 1983).
markets are not normally distributed. Large swings (3 to 6
standard deviations from the mean) occur in the market
far more frequently than the normal distribution There are no taxes or transaction costs
assumption would predict. While the model can also be
justified by assuming any return distribution which is Real financial products are subject both to taxes and
jointly elliptical, all the joint elliptical distributions are transaction costs (such as broker fees), and taking these
symmetrical whereas asset returns empirically are not. into account will alter the composition of the optimum
portfolio. These assumptions can be relaxed with more
complicated versions of the model.
Correlations between assets are fixed and constant
forever
All investors are price takers
Correlations depend on systemic relationships between
the underlying assets, and change when these relation- Their actions do not influence prices. In reality,
ships change. During times of financial crisis, all assets sufficiently large sales or purchases of individual assets
tend to become positively correlated, because they all can shift market prices for that asset and others (via
move (down) together. In other words, the MPT fails to cross-elasticity of demand). An investor may not even be
function when investors are most in need of protection able to assemble the theoretically optimal portfolio if the
from risk. market moves too much while they are buying the
required securities.

All investors aim to maximize economic utility

Any investor can lend and borrow an unlimited
Investors aim to maximize economic utility in order to amount at the risk free rate of interest.
make as much money as possible, regardless of any
other considerations. This is a key assumption of the In reality, every investor has a credit limit.
efficient market hypothesis, upon which the MPT relies.

All securities can be divided into parcels of any size

All investors are rational and risk-averse
In reality, fractional shares usually cannot be bought or
This is another assumption of the efficient market sold, and some assets have minimum order sizes.
hypothesis, but we now know from behavioural More complex versions of the MPT take into account a
economics that market participants are not rational. It more sophisticated model of the world (such as one with
does not allow for "herd behaviour" or investors who will non-normal distributions and taxes) but all mathematical
accept lower returns for higher risk. Even gamblers models of finance still rely on many unrealistic premises
clearly pay for risk, and it is possible that some stock as stated previously.
traders will pay for risk as well.

APPLICATION OF THE MODERN PORTFOLIO

All investors have access to the same information at
THEORY
the same time

This also comes from the efficient market hypothesis. In- The MPT assumes that investors are risk averse,
fact, real markets contain information asymmetry, insider meaning that given two portfolios that offer the same
trading, and those who are simply better informed than expected return, investors will prefer the less risky one.
others. Thus, an investor will take on increased risk only if
compensated by higher expected returns. Conversely, an
investor who wants higher expected returns must accept
Investors have an accurate conception of possible more risk. The exact trade-off will be the same for all
returns investors, but different investors will evaluate the trade-off
differently based on individual risk aversion chara-
The probability beliefs of investors match the true cteristics. The implication is that a rational investor will
distribution of returns. A different possibility is investors' not invest in a portfolio if a second portfolio exists with
24 J. Account. Taxation

a more favourable risk-expected return profile – that is, if rate per unit of risk for any available portfolio with risky
for that level of risk an alternative portfolio exists which assets. Or, a portfolio with the maximum Sharpe ratio.
has better expected returns.
The MPT is therefore a form of diversification. Under
certain assumptions and for specific quantitative defini- Step four: Create the capital market line
tions of risk and return, MPT explains how to find the best
possible diversification strategy. According to capital market theory, investors who allocate
their capital between a riskless security and the risky
portfolio (M) can expect a return equal to the risk-free
Applying the theory rate plus compensation for the number of risk units they
accept. In other words;
The Portfolio theory (MPT) approach has four basic
procedures: Security valuation-describing a universe of
assets in terms of expected return and expected risk; Step five: The optimal portfolio
asset allocation decision- determining how assets are to
be distributed among classes of investment, such as Finally, we are ready for our optimal portfolio. Optimal
stocks or bonds; portfolio optimization-reconciling risk portfolio is represented by the point of tangency between
and return in selecting the securities to be included, such the capital market line and the Markowitz efficient frontier.
as determining which portfolio of stocks offers the best The theory is a mathematical model that uses standard
return for a given level of expected risk; and performance deviation of return as a proxy for risk, which is valid if
measurement-dividing each stock’s performance (risk) asset returns are jointly normally distributed or otherwise
into market-related (systematic) and industry/security- elliptically distributed.
related (residual) classifications (Brodie, 2009). Under the model:

1. Portfolio return is the proportion-weighted combination

Step one: Data collection of the constituent assets' returns.
2. Portfolio volatility is a function of the correlations ρij of
Get historical data for all the selected equities. Determine the component assets, for all asset pairs (i, j).
the average weekly (or daily) returns and corresponding
standard deviation in weekly returns. Find the correlation Expected return:
between selected assets.

Step two: Create a Markowitz efficient frontier

The portfolio standard deviation is provided by the follow Where Rp is the return on the portfolio, Ri is the return on
equation: asset i and wi is the weighting of component asset i (that
is, the share of asset i in the portfolio).
σP = sqrt (∑square(wi). square(σi2) + ∑∑ wi .wj.Covij
Portfolio return variance:
Construct different portfolios with given target returns
(0.001, 0.002, etc.) and use the “solver” in excel to find
weights such that the standard deviation for the portfolio
(expressed previously) is minimized. Then, plot these
portfolios with return on y-axis and risk or standard
deviation on x-axis. The resulting envelope curve is Where ρij is the correlation coefficient between the
called the “Markowitz efficient frontier“. All the portfolios returns on assets i and j.
on this frontier are efficient in the sense that any portfolio Alternatively the expression can be written as:
beneath this line will not provide a better risk-return
alternative (either the portfolio will have lower return for
given risk or higher risk for given return) (Markowitz, ,
1959, 1952).
Where ρij = 1 for i = j.
Step three: Create the market portfolio
Portfolio return volatility (standard deviation):
Market portfolio is defined as the portfolio with risky
assets that provide highest expected return over risk-free
 Omisore et al. 25

Risk free rate

Figure 2. Efficient frontier. The hyperbola is sometimes referred to as the 'Markowitz Bullet', and is the
efficient frontier if no risk-free asset is available. With a risk-free asset, the straight line is the efficient
frontier.

For a two asset portfolio, we have the following: diversified portfolio of assets. Diversification may allow
for the same portfolio expected return with reduced risk.
Portfolio return: If all the asset pairs have correlations of 0—they are
perfectly uncorrelated—the portfolio's return variance is
the sum over all assets of the square of the fraction held
in the asset times the asset's return variance (and the
Portfolio variance: portfolio standard deviation is the square root of this sum)
(Koponen, 2003).

The efficient frontier with no risk-free asset

For a three asset portfolio, we have the following:
As shown in Figure 2, every possible combination of the
Portfolio return: risky assets, without including any holdings of the risk-
free asset, can be plotted in risk-expected return space,
and the collection of all such possible portfolios defines a
region in this space. The left boundary of this region is a
Portfolio variance: hyperbola, and the upper edge of this region is the
efficient frontier in the absence of a risk-free asset
(sometimes called "the Markowitz bullet"). Combinations
along this upper edge represent portfolios (including no
holdings of the risk-free asset) for which there is lowest
PRACTICAL APPLICATIONS OF THE THEORY IN risk for a given level of expected return. Equivalently, a
INVESTMENT DECISION MAKING portfolio laying on the efficient frontier represents the
combination offering the best possible expected return for
Diversification given risk level (Kent et al., 2001).
Matrices are preferred for calculations of the efficient
An investor can reduce portfolio risk simply by holding frontier. In matrix form, for a given "risk tolerance"
combinations of instruments which are not perfectly , the efficient frontier is found by minimizing
positively correlated (correlation coefficient the following expression:
). In other words, investors can reduce
their exposure to individual asset risk by holding a wTΣw − q * RTw
26 J. Account. Taxation

Where, w is a vector of portfolio weights and i ∑ wi = 1 the loss of the sunk costs (that is, there is little or no
(The weights can be negative, which means investors recovery/salvage value of a half-complete project).
can short a security); Σ is the covariance matrix for the
returns on the assets in the portfolio; is a "risk However, that neither of these cited differences
tolerance" factor, where 0 results in the portfolio with necessarily eliminates the possibility of using the MPT
minimal risk and results in the portfolio infinitely far out and such portfolios. They simply indicate the need to run
on the frontier with both expected return and risk the optimization with an additional set of mathematically-
unbounded; and Ris a vector of expected returns. w Σwis
T expressed constraints that would not normally apply to
T
the variance of portfolio return. R w is the expected financial portfolios.
return on the portfolio. Furthermore, some of the simplest elements of the
The foregoing optimization finds the point on the modern portfolio theory are applicable to virtually any
frontier at which the inverse of the slope of the frontier kind of portfolio. The concept of capturing the risk
would be q if portfolio return variance instead of standard tolerance of an investor by documenting how much risk is
deviation were plotted horizontally. The frontier in its acceptable for a given return may be applied to a variety
entirety is parametric on q. of decision analysis problems. MPT uses historical
Many software packages, including Microsoft Excel, variance as a measure of risk, but portfolios of assets like
MATLAB, Mathematical and R, provide optimization major projects do not have a well-defined "historical
routines suitable for the foregoing problem. variance". In this case, the MPT investment boundary can
An alternative approach to specifying the efficient be expressed in more general terms like "chance of a
frontier is to do so parametrically on expected portfolio return on investment (ROI) less than cost of capital" or
return RTw. This version of the problem requires that we "chance of losing more than half of the investment".
minimize; When risk is put in terms of uncertainty about forecasts
and possible losses then the concept is transferable to
wTΣw various types of investment.

Subject to: Application to other disciplines

T
R w=μ As far back as the early 1970s, concepts from modern
portfolio theory gained relevance in the field of regional
For parameter μ. This problem is easily solved using a science. In a series of seminal works, researchers, such
Lagrange Multiplier (Merton, 1972). as Michael Conroy, modelled the labour force in an
economy using portfolio-theoretic methods to examine
growth and variability in the labour force. This was
Applications to project portfolios and other "non- followed by an extensive literature on the relationship
financial" assets between economic growth and volatility.
More recently, modern portfolio theory has been used
The MPT is gradually being applied to portfolios of to model the self-concept in social psychology. When the
projects and other assets besides financial instruments. self attributes comprising the self-concept constitute a
When applied beyond traditional financial portfolios, well-diversified portfolio, then psychological outcomes at
some fundamental differences between the different the level of the individual such as mood and self-esteem
types of portfolios must be considered: should be more stable than when the self-concept is
undiversified. This prediction has been confirmed in
1. The assets in financial portfolios are, for practical studies involving human subjects.
purposes, continuously divisible while portfolios of Recently, the theory has been applied to modelling the
projects are "lumpy". For example, while we can compute uncertainty and correlation between documents in infor-
that the optimal portfolio position for 3 stocks is, say, 47, mation retrieval (Chandra and Shadel, 2007).
30 and 23%, the optimal position for a project portfolio
may not allow us to simply change the amount spent on a
project. Projects might be all or nothing or, at least, have CRITICISM OF THE THEORY
logical units that cannot be separated. A portfolio
optimization method would have to take the discrete Despite its theoretical relevance, the MPT has been
nature of projects into account. highly criticised; its simplistic assumptions being a
2. The assets of financial portfolios are liquid; they can be predominant bias. Critics question its viability as an
assessed or re-assessed at any point in time. But investment strategy, because its model of financial
opportunities for launching new projects may be limited markets does not match the real world in many ways. In
and may occur in limited windows of time. Projects that recent years, basic underlying assumptions of the MPT
have already been initiated cannot be abandoned without have been grossly challenged by fields such as the
 Omisore et al. 27

behavioural economics. asset pricing investment in all available assets) (Chandra,

Efforts to translate the theoretical foundation of the 2003). This artificially increased demand pushes up the
theory into a viable portfolio construction algorithm have price of assets that, when analysed individually, would be
been plagued by technical difficulties stemming from the of little fundamental value. The result is that the whole
instability of the original optimization problem with respect portfolio becomes more expensive and, as a result, the
to available data. Recent research shows that instabilities probability of a positive return decreases (that is, the risk
of this type disappear when a regularizing constraint or of the portfolio increases).
penalty term is incorporated in the optimization The legitimacy of the modern portfolio theory has been
procedure. challenged by financial analysts who often cite Warren
Buffett as a rule breaker. Warren Buffett, a major financial
market referral with successful financial takeovers in his
The theory does not really model the market resume, is not a typical investor. Unlike the average
mutual fund manager, Buffet often buys companies and
The risk, return, and correlation measures used by MPT then manages them. He provides them with economies of
are based on expected (forecast) values, which means scale, lower cost of capital and the benefits of his
that they are mathematical statements about the future managerial wisdom. And when he takes large portions in
(the expected value of returns is explicit in such companies, he often gets a board seat. So perhaps his
equations, and implicit in the definitions of variance and great returns are more a result of his managerial skills
covariance). In practice, investors must substitute than his investment skills, or some combination of both.
predictions based on historical measurements of asset This, obviously, is not congruent with the line of thought
return and volatility for these values in the equations. of MPT proponents (Sabbadini, 2010).
Very often, such expected values fail to take account of
new circumstances which did not exist when the historical
data were generated. CONCLUSION
More fundamentally, investors are stuck with estimating
key parameters from past market data because the MPT This paper presentation sought to review the relevance of
attempts to model risk in terms of the likelihood of losses, the modern portfolio theory as an investment portfolio tool
but says nothing about why those losses might occur. in portfolio decision making. In the course of the
The risk measurements used are probabilistic in nature, research, the relevance and applicability of the MPT was
not structural. This is a major difference as compared to reviewed, however, it was also established that many
many engineering approaches to risk management. inherent flaws of the theory have marred the efficacy of
the theory. Among other things, its simplistic assumptions
and direct correlation of risks and returns were identified
The Theory does not consider personal, as significant flaws.
environmental, strategic, or social dimensions of Despite the limitations of the theory, it is still widely
investment decisions accepted and further research is being carried out on its
principles. The post modern portfolio theory is a
It only attempts to maximize risk-adjusted returns, without significant advancement of the theory. Post-modern
regard to other consequences. In a narrow sense, its portfolio theory encourages far greater diversification in
complete reliance on asset prices makes it vulnerable to an investment portfolio than does the MPT. By utilizing
all the standard market failures such as those arising the alpha coefficient and the beta coefficient, each of
from information asymmetry, externalities, and public which gauge an investment's performance, investors can
goods. It also rewards corporate fraud and dishonest engineer a portfolio's risk and returns to coincide with
accounting. More broadly, a firm may have strategic or investment objectives. The alpha coefficient measures an
social goals that shape its investment decisions, and an investment's performance relative to its risk; the beta
individual investor might have personal goals. In either coefficient measures an investment's return relative to the
case, information other than historical returns (as market as a whole. The post-modern portfolio theory
suggested by the MPT) is relevant. (PMPT) separates alpha- and beta-generated revenue,
and then considers each individually to maximize their
performance. The PMPT is more adaptable to the
The MPT does not take cognisance of its own effect
individual investor and can gauge risk relative to the
on asset prices
investor's minimum acceptable return (MAR) for an asset.
Diversification eliminates non-systematic risk, but, at the
cost of increasing the systematic risk. Diversification
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