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By Rachel Haig | 01-15-2010 04:15 PM

Is Modern Portfolio Theory Obsolete?

Peng Chen, president of Morningstar's Ibbotson Associates, says MPT in general worked in 2008, but highlights the limits of standard deviation alone as a measure of risk.

Rachel Haig: I am Rachel Haig with Morningstar.com. I'm here today with Peng Chen, President of Ibbotson Associates. Previously we discussed whether diversification failed in 2008, and now we're back to talk about modern portfolio theory. Thanks for joining me today, Peng.

Peng Chen: No problem, Rachel.

Rachel: Typically with modern portfolio theory, the idea is that it balances risk and reward. Did it do that in 2008?

Peng: I think you're asking a really great question, and this really has to go back to what modern portfolio theory is. If you look at modern portfolio theory, one of the key things modern portfolio theory tries to do is really try to mitigate risk. The risk that it mitigates through diversification is the undiversifiable risk part, and the part of risk that it cannot mitigate is the systematic risk part.

So what happened in 2008, of course, the market came down quite a bit, and a lot of the portfolios following modern portfolio theory also suffered. If you look at it, a lot of people automatically draw the conclusion that modern portfolio theory didn't work, because the risk is still there.

But if you look at it, the risk really came in, in 2008, as a systematic risk part, which is the risk that modern portfolio theory did not claim or did not attempt to try to address.

So from that regard, actually, yes there was a lot of risk in 2008, but we believe modern portfolio theory actually continued to work. It's just that the risk happened to be the systematic risk part, and that is not what modern portfolio theory addresses.

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