The Congressional Effect and the Limits of Modern Portfolio Theory
Modern portfolio theory (MPT) is a theory of investment that attempts to maximize expected return for a given amount of risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets within a portfolio. It was first articulated by Harry Markowitz in a groundbreaking article in 1952 entitled “Portfolio Selection.”1
To briefly summarize his findings, he focused on two kinds of risk, the first of which was “systematic” or “market,” which related to the broad economy and included such factors as the overall economy, wars, crop failures, floods, the broad equity market, interest rates, and other macro factors that could not easily be reduced by diversification. The other risk in a portfolio was “unsystematic” or “specific” risk, which related to how an individual stock might perform in ways uncorrelated with the overall portfolio. He showed that by prudently diversifying a portfolio, the risks of individual stocks could be used to reduce the overall volatility of a portfolio and give it greater predictability.
This chapter is a brief overview of modern portfolio theory, which assumes that the market has fully digested all relevant information available at the time of investment. One corollary of this theory is that since the market has full access to data and is efficient, the short-term distribution of stock prices is likely to be so random ...