Edge of Modern Portfolio Theory?
Modern Portfolio Theory with application
In 1952 American economist Harry Markowitz published his article "Portfolio Selection”. Later in 1990, he was awarded a Nobel Prize for his work on modern portfolio theory. The modern portfolio theory (MPT) is a practical method on how investors should construct portfolios based on certain assumptions about risk and reward. The key idea of MPT is an optimal mix of assets in a portfolio to produce higher return without increasing the risk.
For an illustration of the MPT application please see the graph below. On the graph you will see portfolio constricted with investments purely in shares (takers: 'ATVI','BA','CNP','CMA', 'STZ','GPN','MPC','NEM', 'PKI', 'VRTX'). The portfolio universe was simulated using UFG Risk Management Tool “Portfolio Contraction” with 1 000 000 simulations.
Based on this calculation, we can choose optimal portfolio construction based on investor risk tolerance. See below.
Edge of MPT
As was described above, the main idea of MPT is diversification and risk/return concept. Another crucial assumption in Harry Markowitz concept was that capital markets are perfect, meaning that:
- There are no taxes or transaction costs.
- All traders have costless access to all available information.
- Perfect competition exists among all market participants.
But on my part, the most important idea that was behind Markowitz theory is the investor contract portfolio, always considering risk tolerance and trying to minimize risk. In recent times with ESG implementation MPT could be questioned because the Environmental, Social, and Governance (ESG) approach has created new selection criteria for investors, portfolio managers and management companies to pick companies to invest in. The COVID-19 pandemic accelerated the discussion of incorporating ESG approaches in the financial market. Asset managers need to take into account ESG factors alongside classical financial factors in their decision-making process. The main idea behind the ESG approach for asset managers is that the investment decision should consider ESG issues and could significantly affect investment decisions.
So, right now we are standing on the edge of classic MPT for assets allocation and selection to a new approach.