Modern Portfolio Theory (MPT) and Financial Economics: A Theory of Lesser Turf?

16 Pages Posted: 2 Apr 2009

See all articles by Andrey I. Artemenkov

Andrey I. Artemenkov

Westminster International University in Tashkent (WIUT); Ariel University

Date Written: March 23, 2009

Abstract

This Paper attempts to explore the building blocks of the Modern Portfolio Theory (MPT) and show their natural limitations associated with the neoclassical 'more heat than light' paradigm. By treating some investment and valuation aspects and consequences of MPT, it raises concerns over the self-fulfillment (performativity) of MPT. MPT regards socially-driven pricing processes occurring on the capital markets as if those were sterling naturally occurring stochastic processes. Thus instead of substantive economic description of the underlying reality it concentrates on only its numerical representation and, then, proceeds to provide normative implications from this one-sided view. While such research paradigm (MPT) has a rightful degree of validity and (perhaps buoyed by its performativity effects) has proven itself fruitful in the context of liquid capital markets, past decades have witnessed its dramatic over-extension to other investment fields where its mechanistic-laden statistics-intensive aspects are clearly inapplicable and beside the point (particularly in respect of illiquid assets). This resulted in gross mispricings of such assets during their securitization with the ramifications of it leading toward the current financial crisis.

While it is the practical abuses of MPT paradigm (and not the theory itself) that can be laid at the door of the current toxic assets and mispricings debacle, the worldview on which the MPT theory is built is deemed to be a much-overlooked impersonal contributant (to the point that the capital markets crisis we are experiencing is not so much a crisis of institutions or instruments, as a crisis of primary finance-theoretical vision). As we argue, MPT worldview is neither right nor wrong, so much as it is applicable to some investment situations and inapplicable to most, and we make a contention that MPT-based valuation and investment theory henceforward should not hold the monopoly over pricing processes in the markets other than immediate liquid capital markets (For example, it is not appropriate for valuing illiquid (private) business equity, finding enterprise (as opposed to liquid equity) value etc).

Since many investment researchers are in the mode of thinking that MPT is the only available investment and valuation perspective, this Paper also briefly describes attempts to develop and institutionally implement other valuation paradigms stemming from neoclassical and Keynesian Economics. It urges their continuation and real world applications as a promising remedy for current breakdown in capital pricing processes.

Keywords: Applicability of Modern Portfolio Theory (MPT), CAPM, M&M theorems, performativity of MPT, Efficiency assessment and valuation in SOFE (Novozhilov, Kantorovich, Lurje)

JEL Classification: G1, G31, G28

Suggested Citation

Artemenkov, Andrey I., Modern Portfolio Theory (MPT) and Financial Economics: A Theory of Lesser Turf? (March 23, 2009). Available at SSRN: https://ssrn.com/abstract=1367255 or http://dx.doi.org/10.2139/ssrn.1367255

Andrey I. Artemenkov (Contact Author)

Westminster International University in Tashkent (WIUT) ( email )

12 Istiqbol St
Tashkent, 100047
Uzbekistan

Ariel University ( email )

Israel

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