Question

What is the Modern Portfolio Theory and what are the criticism of this theory？

Answer 1

Modern Portfolio Theory teaches us to consider effect of investments from the portfolio perspective, instead of single security perspective. If you concentrate on a single asset, then you are judging the risk and return of that security only. Uncorrelated securities when clubbed under a portfolio tends to reduce the overall portfolio risk. So Modern Portfolio Theory teaches us that we should always select securities which are uncorrelated and form our portfolio. This will help the portfolio to save itself in case one particular sector performs badly. As securities are uncorrelated, so when one sector will perform badly the other sector will perform well. Keeping the return of portfolio stable

Criticism:

It is being noticed that correlation between securities increase during crisis. So the best diversification is not achieved as all securities start to perform badly.

Correlation between assets are not static over time. So as the correlation of assets keep on changing, so the diversification benefit is lost.

Modern Portfolio Theory assumes that investors are rational and risk averse. So there should be no panic in market ever. This is not true. Investors follow herd mentality. They start to sell a good stock, just because others are doing the same. So in that case the diversification benefit as being pointed by Modern portfolio theory will not hold.