Modern portfolio theory and risk management: assumptions and unintended consequences

Beyhaghi, Mehdi; Hawley, James P.

doi:10.1080/20430795.2012.738600

Cited by 20 publications

(11 citation statements)

References 54 publications

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“…Yet modern portfolio theory is based on assumptions, and especially the dominance of return and risk as exclusive decision criteria is both hypothetical (Statman 2005;Hofmann, Hoelzl, and Kirchler 2008) and controversial (Beyhaghi and Hawley 2012). Thus Steuer, Qi, and Hirschberger (2007) and Steuer, Qi, and Hirschberger (2008) propose an important modification: based on multicriteria decision making theory they substitute the assumption of an exclusively risk-returnoriented decision by the acceptance of several investment objectives that are often pursued in parallel.…”

Section: Framework and Empirical Applicationmentioning

confidence: 97%

An equation with many variables: unhiding the relationship between sustainability and investment performance

Peylo

Schaltegger

2014

Journal of Sustainable Finance & Investment

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Financial investment performance of stock portfolios is driven by many factors of influence like portfolio diversification, quality of funds management or gravitational effects of market phases. It is, therefore, quite possible that relationships between sustainability and financial performance elude measurability because they may be overshadowed and dominated by other, more powerful or temporarily more influential factors. Using a new quantitative model for portfolio optimisation that simultaneously controls for both financial and sustainability related effects, we investigate whether and how different levels of sustainability in stock portfolios influence investment return when other factors with known influence on investment performance are neutralised. The model is applied to the German Stock Market Index Deutscher Aktienindex (DAX) for the period of 2003-2012 with regard to varying market phases. The findings show a distinct yet nonlinear relationship between sustainability and investment performance that is especially strong in phases of crisis. These results may indicate a business case for socially responsible investment (SRI) that has not yet been fully capitalised with the existing SRI instruments.

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Section: Framework and Empirical Applicationmentioning

confidence: 97%

An equation with many variables: unhiding the relationship between sustainability and investment performance

Peylo

Schaltegger

2014

Journal of Sustainable Finance & Investment

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“…Lang and Jagtiani (2010) and Beyhaghi and Hawley (2013) agree that the use of sophisticated but untested models of risk management was a key element of the crisis and led to many corporations underestimating risks and engaging in excessive risk taking. Ashby (2010) demonstrates that many financial institutions showed an excessive reliance on quantitative tools and failed to adopt adequate stress and scenario testing.…”

Section: Methodology and Techniquementioning

confidence: 99%

“…A more fundamental problem with risk management is that it rested on unrealistic theoretical assumptions, like the efficient market hypothesis (Beyhaghi and Hawley, 2013;Williams, 2011). The generalized use of these assumptions led to feedback loops and deceived practitioners, which paradoxically made risk management contribute to the increase of risk.…”

Section: Methodology and Techniquementioning

confidence: 99%

Risk management, the subprime crisis and finance-dominated capitalism: what went wrong? A systematic literature review

Lagoa¹,

Leão²,

Barradas³

2015

The Demise of Finance-Dominated Capitalism

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“…Pollet and Wilson (2010) have employed their average correlation approach to predict future SMRs. The economic theory of using average correlation as a variable to predict SMRs originates from the capital asset pricing model (CAPM), the basis of many SMRs prediction studies (e.g., Beyhaghi & Hawley, 2013;Noussair & Tucker, 2013;Chaibi et al, 2015). It starts with an intuitive assumption: when systematic risk rises, risk-averse investors will demand a higher risk premium to offset the possible volatility; in other words, it gives rise to expected returns.…”

Section: Stock Returns Predictability: a Literature Reviewmentioning

confidence: 99%

Predicting stock market returns in the US: evidence from an average correlation approach

Singh

et al. 2020

ARJ

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Purpose This study aims to draw on a less explored predictor – the average correlation of pairwise returns on industry portfolios – to predict stock market returns (SMRs) in the USA. Design/methodology/approach This study uses the average correlation approach of Pollet and Wilson (2010) and predicts the SMRs in the USA. The model is estimated using monthly data for a long time horizon, from July 1963 to December 2018, for the portfolios comprising 48 Fama-French industries. The model is extended to examine the effects of a longer lag structure of one-month to four-month lags and to control for the effects of a number of variables – average variance (AV), cyclically adjusted price-to-earnings ratio (CAPE), term spread (TS), default spread (DS), risk-free rate returns (R_f) and lagged excess market returns (R_s). Findings The study finds that the two-month lagged average correlation of returns on individual industry portfolios, used individually and collectively with financial predictors and economic factors, predicts excess returns on the stock market in an effective manner. Research limitations/implications The methodology and results are of interest to academics as they could further explore the use of average correlation to improve the predictive powers of their models. Practical implications Market practitioners could include the average correlation in their asset pricing models to improve the predictions for the future trend in stock market returns. Investors could consider including average correlation in their forecasting models, along with the traditional financial ratios and economic indicators. They could adjust their expected returns to a lower level when the average correlation increases during a recession. Social implications The finding that recession periods have effects on the SMRs would be useful for the policymakers. The understanding of the co-movement of returns on industry portfolios during a recession would be useful for the formulation of policies aimed at ensuring the stability of the financial markets. Originality/value The study contributes to the literature on three counts. First, the study uses industry portfolio returns – as compared to individual stock returns used in Pollet and Wilson (2010) – in constructing average correlation. When stock market becomes more volatile on returns, the individual stocks are more diverse on their performance; the comovement between individual stock returns might be dominated by the idiosyncratic component, which may not have any implications for future SMRs. Using the industry portfolio returns can potentially reduce such an effect by a large extent, and thus, can provide more reliable estimates. Second, the effects of business cycles could be better identified in a long sample period and through several sub-sample tests. This study uses a data set, which spans the period from July 1963 to December 2018. This long sample period covers multiple phases of business cycles. The daily data are used to compute the monthly and equally-weighted average correlation of returns on 48 Fama-French industry portfolios. Third, previous studies have often ignored the use of investors’ sentiments in their prediction models, while investors’ irrational decisions could have an important impact on expected returns (Huang et al., 2015). This study extends the analysis and incorporates investors’ sentiments in the model.

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Modern portfolio theory and risk management: assumptions and unintended consequences

Cited by 20 publications

References 54 publications

An equation with many variables: unhiding the relationship between sustainability and investment performance

An equation with many variables: unhiding the relationship between sustainability and investment performance

Risk management, the subprime crisis and finance-dominated capitalism: what went wrong? A systematic literature review

Predicting stock market returns in the US: evidence from an average correlation approach

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