Modern Portfolio Theory, or MPT, is an investment strategy for those who are reluctant to accept risk in their investments. In most cases, MPT is applied by using past financial statistics to determine the best investing combination to make the most profit.
The History of MPT
The investment strategy was created in the 1950s, and investors saw enough gains using the tactic to consider MPT an important investment plan. Furthermore, from around 1982 until 1999, the market conditions were perfect for the MPT strategy. As a result, it became widely accepted by financial advisers and investors.
Modern Portfolio Theory and Risk
In the past, investors claimed that they could use MPT to create a stock combination that was as secure as bonds. However, the assertion was frequently inaccurate. Furthermore, the investment strategy may prevent investors from realizing their full profit potential. MPT has several imperfections, but its avoidance of risk is perhaps its biggest fault because volatile stock may result in lost profits or large gains. With MPT, investors focus on lost profits instead of an investment’s potential financial rewards.
Modern Portfolio Theory is Too Specific
When investors use MPT to determine investments, they can calculate the stock’s risk probabilities to 10 decimal places. However, the outcome doesn’t help investors because of performance uncertainty. By computing the correlation between assets, investment advisers will reach an exact number, but if they run the numbers using varying time periods, then they will receive different results. Therefore, an exact answer does not exist for investments as the results will change based upon the time interval used to make the calculation.
Many investors build their programs based on several basic assumptions. For instance, investors may believe that bonds will provide a 5 percent average return for a long-term investment. In addition, numerous advisers are certain that stocks will give investors a 10 percent average return during a lengthy investment period. Some portfolios may include variations based on High Yield and different stock types as well as real estate assets and commodities. Unfortunately, the strategy is flawed because the description of the investment returns is incomplete. Furthermore, MPT fails to use several important investment determinations such as when a financier began investing and the date that he or she sold the investment. The strategy doesn’t even use the sell date for multi-decade investments.
Other Problems with MPT
Keep in mind that traditional asset distribution is unable to deal with the valuation of stocks and bonds in a way that effectively protects portfolios from undergoing drawdowns. Furthermore, according to MPT, investors are unable to make high profits from low risk investments in the stock market. However, oil and gas investments regularly provide large returns with less financial risk. Oil and gas companies accept a great deal of risk when they search for new sources, and as a result, investors have the opportunity for higher returns.
Since MPT has numerous limitations, investors should begin actively investing and determining their asset allocation. Also, be flexible and willing to change an investment strategy at any time. If investors have concerns about taking this step, then they can start slowly with one or more financial managers and funds. In addition, when investors begin choosing their investments based on educated speculation, they will have the opportunity to gain large profits.