Modern Portfolio Theory Essay

1079 Words Aug 8th, 2010 5 Pages
The investment terrain has seen some major changes in the last two decades. Financial and technology companies came and went, stock market values soared, plummeted and rebounded, housing derivatives blew up, and other foundations were laid bare. Even the core of investing theories related to portfolios has come under pressure. Yet the belief in Modern Portfolio Theory has remained strong amongst the investors.
Modern Portfolio Theory (MPT) is a theory that tells investors how to minimise risks associated with investment and at the same time, maximise return on the investments by proper resource allocation and diversifying their portfolios – it is based on the theory that risk can be lessened by diversifying into
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Indeed, as the all-too-familiar warning advises, past performance is no guarantee for future results.
In 1952, Markowitz wrote that the key to forecasting might be found in a mixture of ‘statistical techniques’ and ‘the judgment of practical men’. It could therefore be said that, Markowitz acknowledged that anticipating the future could be as much an art as a science. This helps explain the common tendency to rely on the past as a guide, despite its limitations. After all, in the absence of other tangible information, historical numbers might not be much, but they are something.

In the real world, MPT often requires investors to rethink notions of risk. Sometimes it demands that the investor take on a perceived risky investment (futures, for example) in order to reduce overall risk. That can be a tough sell to an investor not familiar with the benefits of sophisticated portfolio management techniques. Furthermore, MPT assumes that it is possible to select stocks whose individual performance is independent of other investments in the portfolio. But market historians have shown that there are no such instruments; in times of market stress, seemingly independent investments do, in fact, act as though they are related rather than unrelated as most people would think.

Likewise, it is logical to borrow to hold a risk-free asset and increase your portfolio returns, but finding a truly risk-free asset is

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