Lawrence Cunningham is a legal scholar and corporate governance academic who has also written extensively about Warren Buffett (Trades, Portfolio) and Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial). He is the author of an excellent book called "The Essays of Warren Buffett,"Â which organizes various sections of the Oracle of Omaha’s shareholder letters by theme - these include corporate governance, tax and accounting, finance and investing and much more.
In his introduction to the book, Cunningham details the conceptual clash between Buffett’s value investing and modern finance theory.
Why bother picking stocks anyway?
“The most revolutionary investing ideas of the past thirty years were those called modern finance theory. This is an elaborate set of ideas that boil down to one simple and misleading practical implication: it is a waste of time to study individual investment opportunities in public securities. According to this view, you will do better by randomly selecting a group of stocks for a portfolio by throwing darts at the stock tables than by thinking about whether individual investment opportunities make sense.”
By selecting a diversified basket of securities, investors can isolate themselves from the risk of any given one failing - this is known as modern portfolio theory. In this narrative, the only risk that investors need to worry about is that which is measured by beta - a measure of volatility. Previously, I have written about Buffett’s views on treating volatility as risk, as well as what Howard Marks (Trades, Portfolio) has to say on the subject.
“Beta measures this volatility risk well for securities that trade on efficient markets, where information about publicly traded securities is swiftly and accurately incorporated into prices. In the modern finance story, efficient markets rule.”
Rise and fall
The 1980s really were the heyday for modern finance theory. Even though its influence is still significant today, for a while it really was the dominant theory on valuation and risk management:
“Reverence for these ideas was not limited to ivory tower academics, in colleges, universities, business schools, and law schools, but became·standard dogma throughout financial America in the past thirty years, from Wall Street to Main Street. Many professionals still believe that stock market prices always accurately reflect fundamental values, that the only risk that matters is the volatility of prices, and that the best way to manage that risk is to invest in a diversified group of stocks.”
Of course, it was arguably this mismatch in favor of techniques like modern portfolio theory that allowed Buffett to identify so many bargains - if not, one was searching for undervalued stocks that made them much easier to snatch up:
“Being part of a distinguished line of investors stretching back to Graham and Dodd which debunks standard dogma by logic and experience, Buffett thinks most markets are not purely efficient and that equating volatility with risk is a gross distortion. Accordingly, Buffett worried that a whole generation of MBAs and lDs, under the influence of modern finance theory, was at risk of learning the wrong lessons and missing the important ones. A particularly costly lesson of modern finance theory came from the proliferation of portfolio insurance-a computerized technique for readjusting a portfolio in declining markets. The promiscuous use of portfolio insurance helped precipitate the stock market crash of October 1987, as well as the market break of October 1989.”
Cunningham argues these events undermined the monopoly held by modern finance theory in business schools and opened the door for value investing philosophies to proliferate once more.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Will a US-China Trade Deal at the G20 Summit Boost Growth?
- Avoid Value Traps by Steering Clear of the Industries Where They Are Most Prevalent
- Howard Marks: This Time It's Different
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