Synergy of Modern Portfolio Theory and Cointegration

Abstract

The most common method for building portfolios is modern portfolio theory. This theory has been criticised for relying on the correlation measure, which is a short-term measure. In order to address this critique, this study examines whether the Johansen cointegration test improves the efficiency of portfolios based on modern portfolio theory. For this purpose, the co-movements between ten cryptocurrencies and the Nifty 50 are examined, and the long-term portfolios are then optimized by removing the cointegrated assets from the portfolio for the period between April 2019 and March 2022. Due to the prevalence of naive investors in India, naive portfolios were also built and compared to optimal portfolios. The study concluded that the Johansen cointegration test enhances the efficiency of modern portfolio theory and naive portfolios do not overlap with modern portfolios.