(B) Advice to your client for the strength and weakness of MPT. (15 Marks, word count 150- 200 words)

Modern portfolio theory (MPT) is a theory on how risk-averse investors can construct portfolios to maximize expected return based on a given level of market risk.

Strength of MPT

MPT is a useful tool for investors trying to build diversified portfolios. In fact, the growth of exchange traded funds (ETFs) made MPT more relevant by giving investors easier access to different asset classes. Stock investors can use MPT to reduce risk by putting a small portion of their portfolios in government bond ETFs. The variance of the portfolio will be significantly lower because government bonds have a negative correlation with stocks. Adding a small investment in Treasuries to a stock portfolio will not have a large impact on expected returns because of this loss reducing effect.3?

Similarly, MPT can be used to reduce the volatility of a U.S. Treasury portfolio by putting 10% in a small-cap value index fund or ETF. Although small-cap value stocks are far riskier than Treasuries on their own, they often do well during periods of high inflation when bonds do poorly. As a result, the portfolio's overall volatility is lower than one consisting entirely of government bonds. Furthermore, the expected returns are higher.3?

Modern portfolio theory allows investors to construct more efficient portfolios. Every possible combination of assets that exists can be plotted on a graph, with the portfolio's risk on the X-axis and the expected return on the Y-axis. This plot reveals the most desirable portfolios. For example, suppose Portfolio A has an expected return of 8.5% and a standard deviation of 8%. Further, assume that Portfolio B has an expected return of 8.5% and a standard deviation of 9.5%. Portfolio A would be deemed more efficient because it has the same expected return but lower risk.

Weakness of MPT

Perhaps the most serious criticism of MPT is that it evaluates portfolios based on variance rather than downside risk. Two portfolios that have the same level of variance and returns are considered equally desirable under modern portfolio theory. One portfolio may have that variance because of frequent small losses. In contrast, the other could have that variance because of rare spectacular declines. Most investors would prefer frequent small losses, which would be easier to endure. Post-modern portfolio theory (PMPT) attempts to improve on modern portfolio theory by minimizing downside risk instead of variance.