6 Shortcomings of the Modern Portfolio Theory

Modern portfolio theory is a theory that is used to determine the correlation between risk and return when using certain types of investments. It is a very advanced mathematical model that offers some benefits to investors. While it is commonly used, it does have some potential drawbacks. Here are some of the shortcomings of the modern portfolio theory.

1. Does Not Model the Market

The modern portfolio theory is simply a theory and does not actually model the market. The values in the modern portfolio theory are expected returns based on mathematical calculations. In reality, these calculations are rarely correct. When the market actually works itself out, it could be substantially different from what you see on a graph of modern portfolio theory. No statistical model could actually predict, with any certainty, what will happen in the market. This is generally supposed to be used as a guideline. 

2. Assumes No Costs

Another problem with this model is that it does not take into consideration any costs in trading. In reality, when you make a trade in the stock market, you will have to pay a commission to the broker as well as taxes to the government. These two costs can significantly impact your trading and lower your overall returns. When something looks great with a modern portfolio theory graph, you have to lower expectations because it did not allow anything for costs.

3. Assumes All Investors Have Same Credit

In order to make most of this work, the model has to assume that every investor can lend and borrow the same amount of money. When it comes to reality, investors have a specific credit limit with their broker that they can trade. Once they reach the limit, they are done trading until some margin opens back up.

4. Assumes Investors Have Realistic Expectations

This model assumes that investors all have a realistic expectation of investment returns. However, in reality, this is far from the truth. People get overconfident and expect their investments to keep rising in value. Investors regularly hang onto investments too long, or sell them to quickly. In order to make this model work, everyone would have to time everything perfectly.

5. Assumes All Investors are Risk Averse and Rational

Another big assumption that this model makes is that all investors are risk-averse and are completely rational. In reality, many investors enjoy risk and sometimes take on risks that are not wise. They do not think clearly and often trade based on emotion. This model does not take into consideration any of these factors. These factors are very important because most investors use emotion and not everyone is rational.

6. Assumes Investors Have no Impact on Market

Another incorrect assumption that is made with this model is that all investors are price takers. This means that they simply take the price that is available in the market and have no impact on trading prices. In reality, large orders tend to change the price of securities which impacts the model. Every purchase and sell order affects the market, it is all interconnected and linked.

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