Modern portfolio theory and risk management: assumptions and unintended consequences

Abstract

This article presents an overview of the assumptions and unintended consequences of the widespread adoption of modern portfolio theory (MPT) in the context of the growth of large institutional investors. We examine the many so-called risk management practices and financial products that have been built on MPT since its inception in the 1950s. We argue that the very success due to its initial insights had the unintended consequence, given its widespread adoption, of contributing to the undermining the foundation of the financial system in a variety of ways. This study has relevance for both the ongoing analyses of the recent financial crisis, as well as for various existing and proposed financial reforms.