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The Modern Portfolio Theory Flat Earth Society

May 27, 2014
“I’d rather be vaguely right than precisely wrong.” That’s my favorite quote from British economist John Maynard Keynes; it took me a long time to truly appreciate its importance. Math and physics are rooted in equations that spit out precise answers; vagueness there is dangerous — for the right reasons. That is why they are called exact sciences. Investing, despite being taught as an almost exact science, is far from it. It is a craft that falls somewhere between art and science.

A few months ago, while analyzing a company, I asked an executive of a Fortune 500 company what his company’s cost of capital was. The answer I got was, “Well, the beta of our stock is 0.6, and our cost of debt is 3.25 percent, so the cost of capital is 6.35 percent.” Warren Buffett (Trades, Portfolio) was asked about Berkshire Hathaway’s cost of capital at his recent annual meeting. The Berkshire CEO’s answer was vague — “It is what can be produced by our second-best idea” — but it was right.

I am often asked by students if I recommend studying for the Chartered Financial Analyst designation. In the past I always responded with an unequivocal yes. There were many reasons for that: The CFA charter is like getting a master’s degree in finance and investing at a fraction of the cost, and it is valued just as much. Employers like it because it is standardized, and they know what you had to learn. The CFA covers a lot of material, from ethics to financial derivatives.

Lately, however, I have found myself qualifying my yes answer. If you are looking to do the CFA for self-education, I wouldn’t bother. The reason for that is simple: The CFA curriculum spends too much time on Modern Portfolio Theory (MPT). That is the nonsensical set of formulas used by the Fortune 500 executive to compute his company’s cost of capital. (I have to qualify this: I finished my CFA in 2000. Maybe the CFA curriculum has changed since then.)

I’ve been in the investment industry for almost 20 years. I have had thousands of conversations with other investors about stocks, but I have yet to have one conversation in which beta or Modern Portfolio Theory was mentioned as part of the analytical framework — not even once. You hear MPT and beta in the same sentence with other words such as “useless,” “theoretical” and “garbage.” If you were to ask what the beta of any company in my portfolio is, I would have no answer for you; I have simply never looked. But ask me about the return on capital or debt of any stock in the portfolio, and I’ll be right in the ballpark.

MPT — a Noble Prize–winning theory — has lots of flaws. Beta, a mostly random number, is sitting right in the middle of the calculation of MPT. The theory assumes investors are rational — no, that is not a typo. If you are not laughing, you should be: A recent study by Boston-based research firm Dalbar found that the average (rational) investor in U.S. stock mutual funds received an annual return of 3.7 percent during the past 30 years, significantly underperforming the funds in which they invested (they bought high and sold low), as well as the S&P 500 index, which returned 11.1 percent a year during that period. MPT defines risk as volatility, whereas rational people would say that permanent loss of capital is the real risk.

These are not all the flaws, but it would take too much time to go through them. The central flaw of MPT, though, is that it’s a theory with few practical implications. This analytical portfolio framework is used not by analysts or portfolio managers but only by academics and an army of consultants (neither group invests for a living). In other words, by studying MPT your brain cells have died for nothing.

Imagine you are living in the 16th century. Nicolaus Copernicus has already more or less proved that the world is round, but the new textbooks have not yet come out, and the world-is-a-ball theory is not being widely taught. So teachers, who rarely step outside the walls of their own institutions, confidently declare to their students that the world is flat, whereas those who meanwhile roam this wonderful planet more widely (let’s call them entrepreneurs and investors) know perfectly well that it is round. This is pretty much what is happening today with the divide between real-world and academic investment professionals.

If you learn anything by going to the Berkshire Hathaway annual meeting, it is the incredible power of incentives. Berkshire vice chairman Charlie Munger (Trades, Portfolio) is big on that idea. Teachers will teach what is teachable; they’ll default to solving a mathematical equation (while stuffing it with arbitrary numbers for the most part), because that is what they know how to do. They can learn MPT by reading their predecessors’ textbooks, and therefore that is what they’ll teach, too. The beauty of MPT, at least from a teaching perspective, is that it turns investing into a math problem, with elegant equations that always spit out precise, albeit random numbers.

But please don’t tell anyone I said this, because as an investor I’d love for MPT to be taught starting in kindergarten. It would make my job easier: I’d be competing against imbeciles who still believe the world is flat. However, as a well-wishing person dispensing advice, I’d say, spend as little time as you can studying MPT.

About the author:

Vitaliy Katsenelson

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email or read his articles click here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy’s book Active Value Investing (Wiley, 2007).


Visit Vitaliy Katsenelson's Website


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Comments

vgm
Vgm - 7 months ago

" “I’d rather be vaguely right than precisely wrong.” That’s my favorite quote from British economist John Maynard Keynes"

I thought it was generally understood that this quote is mis-attributed to Keynes. A contemporary of Keynes, the British philosopher and logician Carveth Read, is apparently the origin:

http://en.wikipedia.org/wiki/Carveth_Read

aagold
Aagold premium member - 7 months ago

The author seems to be confusing Modern Portfolio Theory (MPT) with the Capital Asset Pricing Model (CAPM). They're not the same thing. CAPM assumes an efficient market where expected return is proportional to "beta". MPT makes no such assumption and is not at all inconsistent with value investing principles. I believe that many value investors, including Warren Buffett, do not fully understand the tenets of MPT. People get way too caught up with this simplistic notion that MPT equates "risk" with "volatility", and therefore they dismiss MPT as garbage. It's just not true. When MPT is applied to long-term time horizons (e.g., 10 years), and risk is associated with *uncertainty of long-term expected rate of return*, it's completely consistent with value investing principles.

vernsumnicht
Vernsumnicht - 7 months ago

It's easy to sound like an investment educator maligning Modern Portfolio Theory (MPT) and belittling Chartered Financial Analysts (CFA) not to mention the implied put down of those who've earned an MBA. This could be taken wrong by young men and women considering an education in finance.

I've lost money in the past (along with many others) inapropriatly applying MPT. I can agree that many investors have been hurt by the way most advisors in the investment industry incorrectly apply the principles of MPT. ERISA and the Prudent Investors Act, in effect, even mandate this incorrect application of MPT's principles. But, the problem isn't with MPT or educaton.

A quick review of the basic tenets of MPT begs the question: Which of the principles derived from MPT are no longer relevant?

• Are investors no longer risk averse?
• Are equity markets no longer pretty efficient?
• Isn't the allocation of the portfolio as a whole important?
• Shouldn't most investors invest for the long-term?
• Is there no longer an Efficient Frontier where every level of risk has an optimal allocation of asset
classes that will maximize returns?
• Would investors rather be concentrated in a few asset classes than be diversified among a greater number of asset classes with low correlation to each other?

Common sense instructs most investors that these basic principles,derived from MPT, remain as relevant today as they were the day they were conceived. Most of the present confusion seems to derive from mean variance optimization (MVO); this is the asset allocation formula used to determine the efficient frontier of optimal (risk adjusted) asset allocation portfolios. But MVO was not intended to be used for managing portfolios, and it should not be considered equivalent to MPT.

Understanding the weaknesses in how MPT is applied enables investors to improve the risk-adjusted returns that their portfolio achieves from asset allocation.

• The asset allocation algorithm shouldn’t use standard deviation to measure risk.
• Asset allocation should be applied using asset classes that have truly low correlation to one another.
• The asset-allocation algorithm needs to be more robust than MVO. That is, more than three basic factors are required to determine optimal asset allocation. Changes in capital market and economic factors, like money supply, inflation, unemployment, dividend yields, etc., need consideration in determining optimal asset allocation.
• The asset-allocation approach should be applied using fee-sensitive investment vehicles to mitigate management, transaction, and tax expenses as much as possible.

The tenets of modern portfolio theory still hold true. What is needed is a rethinking of how to apply the principles of MPT, For more information "click here"

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