Critically analysis of the ‘Modern Portfolio Theory’ – MPT Harry Markowitz’s framework and concept of Modern Portfolio Theory (MPT) is a valuable toolkit used for assessing portfolio construction (Markowitz, 1952). Markowitz demonstrated how, in specific circumstances, an investor’s portfolio selection may be boiled down to balancing two factors; portfolio’s variation and projected return. Through ‘diversification’ of unrelated and uncorrelated assets that have opposing correlations but positive expected returns, investors can maximise returns and minimise risk. The portfolio’s risk, expressed as its variance, will be influenced by both the pairwise covariances of all assets as well as the individual variances of return on various assets. To put it another way, it allowed investors to quantify the risk-return trade-offs they faced. Additionally, he made certain that volatility would serve as the primary stand-in for risk. Charting the risk and returns trade-off in the efficient frontier scatter plot (see Figure 1.), by having the asset classes combined with less correlated assets with balancing, the client can increase the returns with less risk, to improve the risk adjusted return of the portfolio, which works best with asset classes that are less correlated and moving in opposite directions for better diversification and boost returns. Client is best advised to also use historical data through the ‘golden butterfly portfolio’ opportunity which prioritises consistent investment growth with considerations to the economic landscape. Secondly, a recommendation that due to two industries being the same e.g., (FORD) & (GM) being in a shared auto industry which exposes them to comparable risks, they might be equally impacted by market downturns, especially since ‘market trends’ used to predict the next market crash are meaningless compared to ‘asset allocation’ which is the most important decision. Therefore, it is advisable by combining multiple-asset classes, and rebalancing annually to improve the risk adjusted return of their portfolio by approaching different asset classes in other stocks that can be sub-divided into US & International, or to divide them even more into sectors, regions and other markets such as in Bonds, Real Estates, and other alternatives (Elton, et al., 2005). To lower the risk of the portfolio further by adding a total bond market index fund which holds government bonds, corporate bonds, and other bonds, such as. Total US Stock Index (VTSAX or VTI), Total International Stock Index (VTIAX or VXUS) and Total US Bond Index (VBTL or BND).
Figure 1.
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