Assumptions of Modern Portfolio Theory

Modern Portfolio Theory is simply a portfolio management strategy that is bordered on an investor making the best returns on his investment while only sharing in very little risk.

It is based on the foundation of diversifying all securities or financial assets in the portfolio and having them spread across diverse asset classes and industries, but it takes it a step further by knowing the optimal risk-return balance using a mathematical model.

In other words, it represents a mathematical theory of diversification in which case an investor does not just pick individual stocks, but rather creates an entire portfolio, using quantitative methods to determine reward and risk. This theory is based on a myriad of assumptions and some of them are presented below.

The Goal For The Investor Is To Maximize Returns

This seems apparent but it is a valid assumption that MPT rests on. Investors here don’t just want to maximize returns but they want to do so while bearing a certain level of risk. For example, if the risk of two investments are fixed at 10%, MPT rests on the assumption that the investor would go for the investment yielding the higher return in the two.

This also means that every investment alternative has a clear probability distribution of expected returns over a period of time.

Investors Do Not Like To Take Risks

Another assumption here is that investors run away from risk as much as possible. In other words, investors are risk averse. Following from the assumption above, assuming two investment opportunities yield the same amount of returns, they would always opt for the one with the lower risk.

Combining the first assumption with this, it means that if risk is constant, investors would prefer higher returns to lower returns and if on the flip side, the returns are constant, the investors would prefer lower risk to higher risk. This is what leads to the positive relationship between expected return and expected risk.

Investors Know The Risks And The Returns On All Investments

This assumption is what makes MPT a little less realistic. It relies on the fact that investors know the risks and returns on all investments. In a finance class with all variables given, this is perfect.

However, it is a little more complex in the real world. Following closely from this is the assumption that investors base their investment decisions solely on expected risk and return. No further considerations.

All Investors have the exact same knowledge/ information

For investors to be able to make accurate computations, it means all of them have the same information at their disposal and can then make inferences based on it.

While other assumptions were made by Markowitz including that commissions are not part of the decision making process and that risk is measured by the volatility of expected returns, many of these assumptions have been critiqued and termed as flawed.

For starts, the idea that investors act rationally has been criticised. Of course, the fact that transaction costs, taxes, and commission paid are not factored into his formula do not make those costs go away.

Assumptions point in the direction that the actions individual investors make do not affect the overall market when indeed they do. Last, but not least, the idea that future performance can be determined by past performance is flawed. These limitations to the assumptions and more are some of the things that have made MPT only great theoretically.

As such, the investment strategies that still come forth involve not timing the market, diversifying your portfolio, and investing for the long term.

Written by Lawretta Egba.