Is Asset Allocation Broken?
The basis of Asset Allocation was formed in 1952. Numerous advances and complexities have been added to the investing landscape since then while the core concept has largely remained unchanged. While Modern Portfolio Theory (MPT) has been widely influential in investment management, it is not without its limitations and criticisms. Here are some of the downsides associated with MPT:
Assumptions about market behavior: MPT assumes that asset returns follow a normal distribution and that correlations between assets remain constant over time. However, these assumptions may not hold true in reality, particularly during periods of market stress or when dealing with complex financial instruments.
Reliance on historical data: MPT heavily relies on historical data to estimate expected returns, volatilities, and correlations. However, historical data might not accurately represent future market conditions, especially during periods of financial crises or rapid market changes.
Sensitivity to inputs: MPT outputs, such as asset allocation and expected returns, are highly sensitive to the inputs used in the model, such as expected returns, volatilities, and correlations. Small changes in these inputs can significantly impact the resulting portfolio allocations and performance.
Ignoring tail risk and extreme events: MPT assumes that asset returns are normally distributed, which implies that extreme events or tail risk are rare occurrences. However, in reality, financial markets can experience high levels of volatility and extreme events that MPT does not adequately capture.
Lack of consideration for investor preferences: MPT assumes that investors are solely motivated by maximizing returns and minimizing risk. However, investors may have varying risk tolerances, investment horizons, and financial goals, which are not explicitly considered in the model.
Inability to predict market movements: MPT does not provide a mechanism for predicting future market movements or identifying mispriced securities. It primarily focuses on optimizing portfolio allocations based on historical data and risk-return trade-offs.
Simplified view of risk: MPT commonly uses standard deviation as a measure of risk, assuming that investors are risk-averse and only concerned with volatility. However, this measure may not adequately capture all dimensions of risk, such as liquidity risk, credit risk, or behavioral biases.
Difficulty in implementing assumptions: MPT assumes that investors have access to all relevant information and can freely trade assets without transaction costs or restrictions. In reality, transaction costs, market liquidity, and regulatory constraints can limit the ability to implement the ideal portfolio allocation suggested by MPT.
It's important to note that while MPT has its limitations, it still provides a useful framework for portfolio construction and risk management. At Sevey Wealth, we continue to incorporate the core MPT principles while also considering other factors and approaches to enhance portfolios. We believe that building truly customized portfolios around goals and preferences is clearly a superior approach.
This was originally published Jun 17, 2023
