The unique risks of portfolio leverage: why modern portfolio theory fails and how to fix it

Leverage entails a unique set of risks, such as margin calls, which can force investors to liquidate securities at adverse prices. Modern Portfolio Theory (MPT) fails to account for these unique risks. Investors often use portfolio optimization with a leverage constraint to mitigate the risks of leverage, but MPT provides no guidance as to where to set the leverage constraint. Fortunately, MPT can be fixed by explicitly incorporating a term for investor leverage aversion, as well as volatility aversion, allowing each investor to determine the right amount of leverage given that investor’s preferred trade-offs between expected return, volatility risk and leverage risk. Incorporating leverage aversion into the portfolio optimization process produces portfolios that better reflect investor preferences. Furthermore, to the extent that portfolio leverage levels are reduced, systemic risk in the financial system may also be reduced.