Modern Portfolio Theory ( MPT) is popular and postulates, that by diversifying across a number of uncorrelated assets you can reduce the risk on your portfolio and increase the overall rate of return at the same time. Will it work in Forex trading and should you use it, as part of your Forex trading strategy? Let's take a look at the logic of the theory in more detail.
The theory was developed in the 1950s and its key point was, to postulate that different assets were affected by different inputs and therefore, would move independently of each other therefore, if you blend a portfolio of the right assets which are un-correlated, you have the chance to maximize returns and decrease risk at the same time. The idea is to spread the risk, to reduce downside volatility and combine assets, with the potential for growth which would lead to a maximizing of returns and at the same time, this spread of uncorrelated assets would decrease the downside volatility of the portfolio.
Modern Portfolio Theory Applied to Forex Trading
In Forex trading you have only one asset class ( currency pairs) but you do have a huge amount of currency pairs to choose from in the majors against the USD and also a huge variety of crosses, minor and exotic currencies. So can the theory, work in a Forex trading strategy to maximize returns while at the same time, reduce risk?
Modern Portfolio Theory Flaws
The theory is complete nonsense and is a bit like the 2% rule of risk per trade, it's a theory based on mathematics which forgets, markets are not efficient and don't move to mathematical formulas and investors will never be rational in their trading or investing. Financial returns on a portfolio do not conform to a Gaussian distribution or any other type of symmetric distribution. Furthermore correlations between asset classes or currencies, are not fixed forever. Correlations can vary depending on, both external events and the emotions of investors trading.
Mathematicians are always working out clever theories for Forex risk reduction. The theories are always very complex and clever and the standard deviation model in MPT is no different. The theory is well thought out and there is no point in boring you with the maths because, the theory is of no use for trading Forex, stocks or any other financial market. In terms of a Forex trading strategy, to much diversification will mean a reduction in profit potential for the account. This is because, the trader or manager, will not be trading just the best trades but also trades which they think, will reduce risk on the portfolio which of course do nothing to reduce the risk or increase the potential return.
Diversification – MPT and a Trading Edge
There is no logical reason why diversifying reduces risk because – you can lose on one trading signal in the market or 20, if your strategy doesn't have sound logic and a trading edge. Another dumb quote in money management is that even a poor trading strategy can make money if it has good risk control and money management which is a ridiculous statement. The only way a trading system will win long term is if it has a trading edge which can be exploited and if it does, it should simply focus on the best trade in line with its system rules or parameters
If there is no trading set up to trade with the strategy, its better to place more equity against the high odds trades and leave the rest of the money in the bank - rather than trading an uncorrelated asset or currency for the sake of it.
Modern Portfolio theory was introduced by Harry Makowitz in a 15-page article published in the March 1952 Journal of Finance and the theory became hugely popular with investors and money managers and many still use it today and many investors like the concept and who wouldn't? Making the biggest possible gains, with the lowest downside risk? The problem is it doesn't work and in my view, it reduces the chances of making big gains and does NOTHING to reduce risk. Markowitz achieved great acclaim for the theory and was awarded the Nobel Prize in Economics in 1990 along with Merton Miller and Bill Sharpe.
Markowitz calls MPT simply as "Portfolio Theory," because as he says "There's nothing modern about it." He's right about that “not putting your eggs all in one basket” was seen as sound financial advice many years before MPT, tried to model the theory mathematically. There is nothing modern about it for sure and nothing useful to be found in it for traders wanting to reduce risk and increase returns.