The global financial crisis of 2008, followed by the Covid-19 pandemic, has made fundamental changes to the way financial markets work. Interventions by central banks, designed to save economies from major dislocations, have shaken some of the basic concepts investors have been applying for decades. As a result, we need to revisit these ideas with fresh eyes and update them for a new era.
Consider one pillar of finance theory: portfolio construction. Harry Markowitz’s Modern Portfolio Theory (MPT), conceived in the 1950s, was a dramatic leap forward in financial thinking, not only providing investors with a means to measure risk but also allowing them to quantify the marginal benefit of adding new exposures into a portfolio. But many of its assumptions are challenged in the current environment, where large-scale quantitative easing has changed the relationship between risks and returns.
The main concept that needs to be interrogated is the definition of risk itself. Historical volatility is often used as shorthand for riskiness in some popular models derived from the MPT framework. This is obviously insufficient. Risk cannot be reduced to one backward-looking statistic. It has to be about permanent loss of capital, which is the real threat investors face.
Moreover, it should be…