Limitations of Modern Portfolio Theory (MPT)

Even though Modern Portfolio Theory is widely accepted and applied by investment institutions, it has been criticized as well. Particularly, the representatives of behavioral economics, behavioral finance challenge the MPT assumptions on investor rationality and return expectations. However, regardless the criticism MPT is a working investment diversification strategy that is implemented by risk managers, portfolio and investment institutions.

Criticism of Modern Portfolio Theory

Being widely and popularly used by investment institutions, Modern Portfolio Theory still has been subjected to various criticisms. The assumptions made by Markowitz have been criticized due to research findings in other fields of study, particularly within behavioral economics. The behavioral economists have proven that the assumption on "investors' acting rationally" is wrong. In the same way the studies carried out in the area of behavioral finance, have challenged the idea that all investors have exact idea of potential returns, as normally the expectations of investors are biased.

Modern Portfolio Theory, Limitations of MPT

The opinion that investors do not need to pay any taxes or transaction costs does not hold true. The assumption that investors can buy securities of any sizes is claimed not to be practical, since some securities have the minimum order sizes, and securities cannot be bought or sold in fractions. Besides, investors have a credit limit which does not allow them to lend or borrow unlimited amounts of shares.

The critics also challenge the idea that the actions of investors do not have an influence on the market; it is claimed incorrect, as great amount of sale and purchase of separate securities has an impact on the price value of the security or related securities. Besides, the correlations between assets are never stable and fixed; they tend to change together with the changes in the universal relations, existing between fundamental assets.

Furthermore, the theory does mathematical calculations on expected values, based on past performance to measure the correlations between risk and return. However, experienced investors consider past performance not to be a guarantee of future performance. Taking into account only past performances leads to overpassing newer circumstances, maybe not having existed during the time when the historical data were compiled.

Vital Importance of MPT for Risk Management

In spite of criticism, the theory is of vital importance when it comes to financial risk management. It is vastly used by portfolio managers and when developing investment diversification strategies. MPT proves to be highly advantageous and highly appreciated among investors, as the results of its implication lead to portfolio optimization with either the same expected return with less risk than before or a higher expected return with the same level of risk.

The theory is an essential tool when it comes to avoiding financial ruin, as traders cannot simply rely on a single investment for financial stability. Through diversifying one’s investments among several asset classes, containing options, bonds, stocks, futures contracts or precious metals, the probability of undergoing financial blow will be reduced even if one or two investments suffer.

Modern Portfolio Theory has played an essential role in the further development of portfolio trading methods, as well as their management as of today. One of the achievements in this sphere that has reached its perfection, providing investors and traders with all the required conditions to get the highest profit with the lowest risk is GeWorko Method. The Method is based on the already well-worked out principles of portfolio theory, meanwhile, representing quite a new approach and range of opportunities in the financial markets.

It is the first in its kind when it comes to opportunities and created conditions for effective trading and risk management. GeWorko Method, based on NetTradeX platform, allows any trader, investor to realize diverse trading strategies, by allowing to combine assets of their choice and create unique personal instruments. Multiple strategies become possible alongside with investment diversification, through using hundreds of assets of different classes, offered on the platform. It is possible to conduct a thorough retrospective market analysis, as well as use vast technical analysis tools. All these features are oriented towards the investors’ benefits and make it possible to make a profit through minimizing the risk of loss.