Updating Modern Portfolio Theory for Investor Behavior
To construct an optimal portfolio for any investor requires knowledge of two quite different types.
Most obviously, we need to have some knowledge of investments: What is the expected risk and return of all the assets we could use to build the portfolio, and to what degree are they likely to rise or fall together? Secondly, if we are to succeed in combining these into optimal portfolios, we need to understand investors: In particular, we need to know exactly what trade-offs between risk and return each investor is prepared to make. Without this knowledge we may well design a portfolio that is optimal ... but optimal for whom?
The core model used by the financial services industry to construct optimal portfolios of risky assets, known as modern portfolio theory (, was developed almost 60 years ago. This model embodies a number of brilliant insights, still relevant today, about how investors should combine assets in an efficient way to simultaneously reduce expected risk and maximize expected return to attain a portfolio that displays the optimal trade-off between the two for each individual investor. However, 60 years ago our state of knowledge was considerably lower than it is today, in many crucial areas: