Is modern portfolio theory still valid?

[theObserver]

I recently discovered Modern Portfolio Theory (MPT) which I believe is still the standard approach towards portfolio management and the philosophy behind the famous the 60:40 balanced portfolio.

I would like to discuss if MPT is still valid in 2024 and beyond.

MPY was created in the 1950's in a very differnt world. The main area of concern is the assertion that bond and stocks have a negative correlation. That is, both are very differnt financial instruments and what affects stocks does not affect bonds. This negative corrleation allows investers to manage risk by holding and selling bonds when stocks are down and rebalancing later and vice verse.

One problem is this negative corrleation between stocks and bonds is not always true. It's usually true but not always and some fund managers are looking towards alternatives to manage risk. See: https://www.ftadviser.com/asset-all...the-changing-face-of-modern-portfolio-theory/

I believe it's also true that the bond/stock split does not protect a portfolio against inflation. For this some investers choose to hold gold, or commodities or utilities or even crypto.

So what do the readers of AskAboutMoney think about MPT? Is the old 60/40 portfolio outdated as bonds are no longer a good hedge against stocks risk? Is there an viable alternative?

 

[joe sod]

It worked OK until covid and negative interest rates, that resulted in bonds getting over inflated in price and probably too much money sitting in bonds because they never went down in value like stocks did, therefore it was easy for fund managers to over allocate to bonds. Now since covid and the return of inflation bonds have been crushed, they have fallen in value whereas the stock markets have more than made up for inflation. Therefore 60 40 is way too much money allocated to bonds, however in the short term with cuts in interest rates maybe these funds will do ok . However interest rates are still too low from a historical view point of view

 

[Duke of Marmalade]

I too am recent to MPT. It is an elegant theory with nice results culminating in the Capital Market Line. But its elegance derives from some fairly grand, albeit reasonable, assumptions such as folk measure risk by the one year variance of returns, fine, but somewhat more hairy that everybody agrees on the expected returns, variance and correlations of all the assets at play.
The first key result is that there is an Efficient Frontier of portfolios of equities. That is for every risk there is a portfolio which gives the maximum expected return. For a start this underpins the common sense that "diversification is good".
But more striking is that, in fact, there is only one efficient portfolio of equities and that any risk/reward profile would be satisfied by holding a proportion of this portfolio. This is seen from the Capital Market Line. Key to this is that the proportion that is not invested in equities carries no risk. This can be cash or, as a proxy, bonds. All this ignores that every asset including none carries an inflation risk (except index linked bonds).
This result has had an impact beyond confirming the benefits of diversification. It says that the only efficient portfolio of equities is the whole market in those proportions. Hence this is a credo for passive investment and this has become very significant.
The other legacy of MPT is the concept of the Beta of a stock, which measures its risk relevant to the market.
There has been gazillions written about MPT and its spin-offs so it has given more material for academics rather than practitioners though its basic thrust still has practical merit, but it is not a holy grail.
Not sure about 60/40; MPT itself does not arrive at 60/40. I guess that at some stage the empirical evidence suggested that this was the most efficient mix, but I don't think that it has any theoretical basis.

 

[Dr Strangelove]

Therefore 60 40 is way too much money allocated to bonds

I mean it certainly was when interest rates were negative and could go no lower…..not so clear now when interest rates have plenty of room to fall again and fixed income prices would rise.