Modern Portfolio Theory and Risk Management: Assumptions and Unintended Consequences

36 Pages Posted: 7 Sep 2011

See all articles by James P. Hawley

James P. Hawley

Saint Mary's College of California; TruValue Labs

Mehdi Beyhaghi

Federal Reserve Banks - Federal Reserve Bank of Richmond

Date Written: May 10, 2011

Abstract

The article presents an overview of the assumptions and unintended consequences of the widespread adoption of modern portfolio theory (MPT) in the context of the growth of large institutional investors. We examine the many so-called risk management practices and financial products that have been built on MPT since its inception in the 1950’s. We argue that the very success due to its initial insights had the unintended consequence, given its widespread adoption, of contributing to the undermining the foundation of the financial system in a variety of ways. This study has relevance for both the on-going analyses of the recent financial crisis, as well as for various existing and proposed financial reforms.

Keywords: Prudent Investor Standard, Modern Portfolio Theory, Risk Management, Pension Funds, Portfolio Management, Herding and Widespread Adoption, Unintended Consequences, Model Assumptions

JEL Classification: G14, G23, G11, G00, D70, D80, C92, G28, K22

Suggested Citation

Hawley, James P. and Beyhaghi, Mehdi, Modern Portfolio Theory and Risk Management: Assumptions and Unintended Consequences (May 10, 2011). Available at SSRN: https://ssrn.com/abstract=1923774 or http://dx.doi.org/10.2139/ssrn.1923774

James P. Hawley (Contact Author)

Saint Mary's College of California; TruValue Labs ( email )

San Francisco, CA 94105
United States
510-928-1327 (Phone)

Mehdi Beyhaghi

Federal Reserve Banks - Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

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