Modern Portfolio Theory: Applications and Limitations

Foundational Framework and Contemporary Challenges

Harry Markowitz's Modern Portfolio Theory remains foundational to institutional investment management, yet practical implementation reveals significant limitations that require sophisticated adaptations for contemporary portfolio construction.

Assumption Limitations in Practice

The classical mean-variance optimization framework assumes normal return distributions, stable correlations, and known expected returns. However, empirical evidence demonstrates that asset returns exhibit fat tails, time-varying volatility, and unstable correlation structures that challenge these fundamental assumptions.

Enhanced Optimization Techniques

Our research addresses these limitations through enhanced optimization techniques including robust optimization, Black-Litterman model enhancements, and regime-aware portfolio construction. We examine how institutional investors can incorporate alternative risk measures beyond variance, including conditional value-at-risk and maximum drawdown constraints.

Practical Implementation Solutions

Practical considerations for institutional implementation include estimation error in expected returns, the curse of dimensionality in large-scale optimization, and the integration of alternative assets with non-normal return characteristics. We present systematic approaches that extend MPT principles while addressing real-world portfolio management challenges.

Evolution of Portfolio Construction

The evolution toward factor-based models, dynamic risk budgeting, and multi-period optimization represents the natural advancement of Markowitz's original insights, providing institutional investors with more robust portfolio construction methodologies.