Skip to main content
ReviewSustainable investing

Moving Beyond Modern Portfolio Theory:

A Review

By July 12, 2021May 3rd, 2023No Comments

(Note: Jon Lukomnik is a fellow of High Meadows Institute)

When modern portfolio theory arrived on the scene in the 1950s, it was considered revolutionary. It changed the way that investors perceive risk, return and portfolio management and permanently altered the investing world and financial markets.

But has modern portfolio theory outgrown its usefulness in the 21st century? In their new book, Moving Beyond Modern Portfolio Theory: Investing That Matters, authors Jon Lukomnik and James P. Hawley argue that it has.

Modern portfolio theory (or MPT), introduced by economist Harry Markowitz in 1952, maintains that an individual investment’s risk and return should not be viewed alone but in terms of how the investment affects the overall portfolio’s risk and return. This allows investors to create a portfolio of diversified assets that will maximize returns for a given level of risk (or minimize risk for a given level of expected return).

So far, so good.

But MPT also claims that investments are impacted by systemic risk stemming from the social, environmental and financial systems underpinning society and that investors must simply accept this non-diversifiable market risk because there is nothing they can do to alter it.

This, Lukomnik and Hawley argue, is where MPT fails.

Studies have found that systematic market risk (or “beta”) has a much greater effect on investment returns than an investor’s ability to choose the right portfolio of stocks, suggesting that, if MPT is to be believed, the part of the process that investors have the most control over matters the least. The authors call this “the MPT paradox.”

Moreover, they assert that MPT’s fundamental understanding of systemic risk is faulty: systemic risk does impact investments, but investments also impact systemic risk. Whereas MPT views investing as divorced from real-world cause and effect, the authors contend that investments can and do play a role in mitigating – or exacerbating – systemic challenges, from climate change to income inequality, that contribute to market risk.

This, in turn, suggests that focusing on system health can improve overall market returns and that adding a system-level investing lens to investment strategies can lessen many of the causes of system risk that impact the market as a whole.

Moving Beyond Modern Portfolio Theory traces the roots of MPT, the assumptions and hypotheses underlying it and the market-dominant theories that have emerged around it, exploring the ways in which it both broke new ground and is now deeply flawed. The authors argue that its narrow focus on reducing volatility, while overlooking the root causes of the risks that create volatility, ignores the feedback loop between investing and the real world and provides no tools for investors to deal with systematic risks.

Though the book primarily focuses on why and how economic theory needs to evolve beyond MPT, the authors also suggest approaches and strategies investors can employ to confront this challenge and indeed show how some of the world’s biggest investors have in practice already progressed beyond the limitations of current theory in ways that impact our social and environmental systems. From BlackRock’s attempts to combat climate change by setting standards for ESG reporting, to State Street’s work advocating for greater gender diversity in corporate boardrooms, investors are beginning to embrace universal ownership and “beta activism,” addressing systematic risk across the marketplace, rather than targeting individual companies.

Moving Beyond Modern Portfolio Theory is a groundbreaking book that offers a bold and thoughtful critique of one of the most influential economic theories of the 21st century. Lukomnik and Hawley provide an insightful analysis of the limitations of current economic thought and make a powerful case for the need to modernize modern portfolio theory.