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IAI Actuarial Core Principles · Economic Modelling · Mean-variance portfolio theory

Which of the following is a recognised limitation of mean-variance portfolio theory when applied to real investment returns?

Variance counts upside and downside deviations equally, so for skewed or non-normal returns it can misrepresent the risk investors care about. This is a key limitation of mean-variance theory, which otherwise does use expected returns and promotes diversification.

  1. AVariance penalises upside and downside deviations equally, so it may misrepresent risk for skewed returnsCorrect
  2. BIt requires investors to hold only a single risky asset
  3. CIt assumes that all investors have identical risk-free borrowing rates of zero
  4. DIt cannot be used when asset returns have positive expected values
  5. It ignores the expected return of each asset

Explanation

Mean-variance theory uses variance as the risk measure, which treats gains above the mean as risk just as much as losses. For skewed or asymmetric returns this misdescribes investor concerns. The other options misstate the theory: it uses expected returns, encourages diversification, and has no requirement of zero rates.

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