Analysis of the Limitations of Portfolio Theory

Abstract

Portfolio theory quantifies the risks and returns in the portfolio for the first time, and puts forward effective frontier model to provide scientific and quantifiable indicators and basis for investors' investment decisions. However, the theory is based on a series of perfect assumptions, which are not true in reality. Therefore, the application of the theory in the real financial market will inevitably have limitations. This paper mainly demonstrates the defects of the hypothesis through the phenomena in China's financial market, and then explains the limitations of portfolio theory. The case study shows that the market is not completely effective. The market will cause non-random stock price fluctuations and the violation of the law of one price due to imperfect information disclosure. In addition, investors are affected by cognitive bias, and their investment behaviour is not completely rational. This study illustrates and confirms the limitations of portfolio theory, and puts forward the direction for improving the model assumptions.