The Practical Implications of Modern Portfolio Theory

Abstract

The practical implications of modern portfolio theory (MPT) are obscured by more than 50 years of academic literature. We shed light on the literature by picking out the few most important implications of MPT. We argue first that what we dub the “Markowitz uncertainty principle” implies that mean-variance efficient portfolios are a practical impossibility, and that attaining “pragmatic diversification” should instead be the goal of investors. We also argue that MPT is silent as to whether any fund manager can or should be able to beat his or her benchmark consistently. We can, however, combine the MPT framework with existing empirical evidence to generate practical advice about active investment for retail investors. For capital budgeting, we argue that the literature implies that the original single-beta capital asset pricing model (CAPM) should typically be implemented using a multi-beta framework.

Keywords: Markowitz, CAPM, Diversification, Capital Budgeting, Active Management

JEL Classification: G11, C61