Module 3: Establishing a sound long-term investment strategy | Blog 3-2: Diversification by David S. Krause

In Lesson 3-2, you were introduced to Harry Markowitz and Modern Portfolio Theory (MPT). As stated, this theory was initially under attack by academics and practitioners in the 1960s; however, it eventually became the cornerstone of much of today’s accepted financial theories.

Harry Markowitz

Harry Markowitz

It is fair to point out that Markowitz’s Modern Portfolio Theory is based on a number of heroic assumptions. In mathematics, we believe that the results from models are correct as long as the underlying assumptions are correct. In science, we have basic theories and principles and as long as the fundamental pieces fit, equations can be utilized to provide useful insights. That’s the way we’ve been able to develop a thorough understanding of the far reaches of the universe or the predict the behavior of subatomic particles that we can’t even observe.

Since Modern Portfolio Theory is based on a basic model that’s been mathematically proven, it should be without dispute, right? Well, not exactly. There are some very significant assumptions surrounding MPT which are listed below. Here are eight of the underlying assumptions that have caused some people to reject Markowitz’s portfolio theory:

  • There are no transaction costs in buying or selling securities.
  • There is no spread between bid and ask prices.
  • No taxes of any kind are considered and only “risk” determines which securities an investor will buy or sell.
  • Investors do not consider taxes when making investment decisions and are indifferent to receiving dividends or capital gains.
  • Investors can buy or sell any amount of any security and liquidity is not issue.
  • Investors have the same time horizon.
  • Access to information is the same for all investors.
  • Investor psychology and public events have no effect on the markets.

MPTThese assumptions don’t reflect the realities of the real world. So does this invalidate Modern Portfolio Theory? No, but it muddies the water a bit and makes it less certain than Harry Markowitz modeled it in the 1950s.

Unquestionably, diversification is good, but it is not the end of the discussion – real world factors also need to be considered. During the financial crisis of 2008 it seemed as if all assets were perfected correlated and the benefits of diversification were non-evident – a clear case where the assumptions did not hold. But does this invalidate the theory and make Markowitz’s work irrelevant? No. He was clear in stating the assumptions of the model and warning that investors should be careful before accepting the theory carte blanche.

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