Did Modern Portfolio Theory Survive the Bear Market?

The following in an excerpt from an article by Arijit Dutta, associate director of mutual fund analysis with Morningstar.

 Two bear markets in one decade have shaken investors' faith in the tenets of Modern Portfolio Theory and the asset-allocation strategies the theory spawned. Critics say that blind faith in MPT led to lopsided asset allocation. The theory did not properly account for systemic risk, which caused investors to allocate too heavily in stocks, and now their portfolios will need years to get even.

Useful but Not Guaranteed

 Some investors leaned too heavily on MPT models as though they were all they needed, but those models still serve a purpose. Diversification is still a great way to reduce risk and earn a higher level of return in the long run. Studies show that asset allocation is still of tremendous importance, even after last year's meltdown.

In fact, most constructive ideas about improving asset allocation retain the basic framework of MPT. These ideas suggest practical tweaks to the theory, rather than any radical remedies. For example, one idea is to improve risk measurement. This means less reliance on the normal distribution and more on other distributions or approaches that entertain the possibility of extreme losses. A combination of lower allocation to especially risky assets and hedging tools can then be used to protect the portfolio. Another suggestion is to engage more in tactical or dynamic asset allocation. Rather than stay with a static allocation to equities, say, this approach involves shifting the mix based on macro views or valuation analysis.

By Arijit Dutta, associate director of mutual fund analysis with Morningstar.