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Modern Portfolio Theory (MPT)

Definition

Modern Portfolio Theory (MPT), introduced by Harry Markowitz in 1952, provides a framework to assemble a portfolio of assets such that the expected return is maximized for a given level of risk, or the risk is minimized for a given level of expected return. It emphasizes the benefits of diversification.

Key Principles of MPT:

  • Efficient Frontier: The set of portfolios that offer the highest expected return for each level of risk or the lowest risk for each level of return.
  • Diversification: Reducing risk by investing in a variety of assets which perform differently under the same economic conditions.

Assumptions in Modern Portfolio Theory (MPT)

Modern Portfolio Theory (MPT) relies on several assumptions about investors and markets, some explicit and others implicit. These assumptions are not entirely accurate and can compromise the theory to a degree.

Assumptions Include:

  • Normal Distribution of Returns: Asset returns are often assumed to be jointly normally distributed. However, real-world data shows that returns are not normally distributed, with large swings more frequent than the model predicts.
  • Constant Correlations: The theory assumes that correlations between assets are fixed. In reality, correlations vary with changes in systemic relationships, such as economic or political events.
  • Economic Utility Maximization: All investors are assumed to aim to maximize economic utility, i.e., making as much money as possible.
  • Rational and Risk-Averse Investors: Investors are assumed to be rational and risk-averse, contradicting behavioral economics findings that demonstrate irrational and sometimes risk-seeking behaviors.
  • Equal Information Access: It's assumed all investors have access to the same information at the same time, ignoring realities like information asymmetry and insider trading.
  • Accurate Return Conceptions: Investors are presumed to have an accurate perception of possible returns, which is often not the case.
  • No Taxes or Transaction Costs: The theory often neglects taxes and transaction costs, which can significantly affect portfolio decisions.
  • Price Taker Assumption: Investors are assumed to be price takers, not influencing prices with their actions, which is not valid for large trades.
  • Unlimited Borrowing at Risk-Free Rate: It assumes investors can lend and borrow unlimited amounts at the risk-free rate, disregarding credit limits.
  • Divisibility of Securities: All securities are assumed to be divisible into any size, which is not practical with certain assets.
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