Dead or alive: Modern portfolio theory based on financial analysis

Abstract

Currently, there are a lot of criticisms on Modern Portfolio Theory (MPT). Black Swan argument claims that in the event of a financial turmoil, the stock prices move beyond what is expected by normal distribution. This study empirically investigates whether it is possible to apply MPT by using additional criteria. The criteria used in this research are related to financial analysis, a well-known field in corporate finance. The ratios used are debt-to-equity and return on equity. According to the analysis, Modern portfolio theory can be applied by the use of these additional criteria. The analysis with debt-to-equity criterion reveals that Portfolios 3 and 5 which have lower debt-to-equity ratios performed better in the period. The analysis with return on equity reveals that only Portfolio 8 which has 9 companies with ratios larger than 0.2 has positive return whereas the other portfolios have negative returns. The results further show that, while applying MPT with these criteria is perfectly possible and sound, the investor could diversify further by selecting portfolios with higher number of securities and still have better financial ratios. This research to the authors' knowledge brings a novelty by proposing these selection criteria in MPT. The suggested method could be applied by practitioners in this field. This study also targets to bring a new direction to the ongoing debate whether the theory of Markowitz (commonly known as father of Modern Portfolio Theory) is dead or alive.