The Absurdity of Modern Portfolio Theory

Justo22

Junior member
14 1
MPT – Strike 1: Investors Are Rational

A friend of mine told me that I should look at the Modern Portfolio Theory (MPT) for some ideas on what to write about. Boy was he right. But first, what is MPT?
MPT is a theory of investment which attempts to maximize a portfolio’s expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. It is also a form of diversification (and you know how I feel about that (if not read my post on diversification)).

MPT is best explained by using a mathematical model, which, in my own opinion, is a bunch of baloney. The only mathematics you need to evaluate companies or stocks is simple adding, subtracting, multiplication and division. That’s it. Now the model works in theory, but in the real world, where there are no save points, it doesn’t even come close to working. This is due to the FACT that it makes a few very grave assumptions. So part one of our journey through the pitfalls of MPT starts now with the assumption that………….

INVESTORS ARRRRRRRE RATIONAL

One of the assumptions that enables MPT to work (in theory) is that investors are rational. I find great difficulty in believing this to be true due to the simple fact that investors are not any different from other people. Investors are people; plain and simple. Now how many people do you know who are completely rational? Take a few pauses here to really think about that……………keep thinking……….




Probably not that many right? And that is because the majority of people (please do not take offense here) are too emotionally driven to be rational. I know you’re not though. 
So now how can investors be rational? Are they some sort of superior being that has evolved to totally abide by the rules of logic and circumstance and admonish most, if not all, of their emotionally weak mindset? Of course not. The majority of investors are not rational. They can be greedy, overzealous, and sometimes frightened when their favourite stock takes a plunge.

As an example let’s look back a few years at some irrational investors who were buying technology stocks. And remember any smart individual (who knows at least a little accounting) could see that the majority of “tech” stocks were grossly overvalued at this time, even though they were very popular.

1. In 1999, Alexander Cheung of (what once was) Monument Internet Fund, after earning 117.3% in the first 5 months of the year, claimed that his fund would gain 50% over the next three to five years and would achieve an annual average of 35% over the next twenty years. Now is he rational? Well, considering most of the fund’s portfolio was comprised of internet stocks which were grossly overvalued, I’d say no he isn’t rational. He got caught up in the market mayhem of internet stocks. Another point to look at is that the highest 20 year return for any mutual fund in history was about 25.8% per year (performed by the great Peter Lynch). Peter’s performance during that period turned $10,000 into more than $982,000, and yet Cheung was saying that he could turn it into over $4,000,000! Obviously that is ridiculously overoptimistic. And here is the point….investors bought it. These “rational” investors threw more than $100,000,000 into Cheungs fund over the next year. By the end of 2002, that $100,000,000 was worth about $20,000,000. A loss of 80%.

2. Alberto Vilar of Amerindo Technology Fund, after a whopping 249% return for 1999, ridiculed anyone who doubted that the internet was a perpetual money making machine: “If you’re out of this sector, you’re going to underperform. You’re in a horse and buggy, and I’m in a Porsche (personally I loled there). Clearly Mr. Vilar was not rational in saying this, as the backbone of the economy at the time was the brick and mortar companies (companies with tangible assets). So clearly this investor, who ran a multimillion dollar mutual fund, is not rational. To showcase this, if you had invested $10,000 at the end of 1999 you would have about $1,195 left by the end of 2002. Makes you sick doesn’t it?

3. James J. Cramer, a hedge fund manager, proclaimed in 2000 that Internet-related companies “are the only ones worth owning right now.” These “winners of the new world are the only ones that are going higher consistently in good days and bad.” Oh man. As with the above examples, he isn’t looking at what these companies are worth. He is looking at the price of the stock. Sorry James, you’re being branded as irrational. By year end 2002, one of the 10 companies in the fund went bankrupt, and a $10,000 investment would have shrunk to about $597.44. That is freaking scary. I’m not sure which new world James was referring to here….oh wait, an irrational world, where people pay for overvalued stocks that won’t make them any money.

The majority of investors are obviously not rational and as long as people are guided by their emotions they never will be.

Strike one MPT. Swing and a miss. The first assumption that investors are rational does not stand up for modern portfolio theory to work.

MPT – Strike 2: Markets Are Efficient

Ready for the next blunder that Modern Portfolio Theory assumes? Are you?!?! Well get ready for the next big assumption that MPT makes which is……………………………

MARKETS ARRRRRRRE EFFICIENT

What this means in that in order for MPT to work the model assumes that markets are efficient, meaning (more or less) that at any given time the price of a stock reflects what a company is worth based on all readily available public information and that prices instantly change to reflect new public information. In very simple terms efficient markets are saying that the market is a weighing machine. Stock prices accurately reflect, at any given moment, what a company is worth.

What all investors need to understand is that the market is only a weighing machine (and only sometimes) in the long run. In the short run, it is a voting machine, and a poor voting machine at that. There will be all sorts of price discrepancies in the short run due to, overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing.
And if markets were efficient there would be very little money to be made, as companies would never become undervalued nor overvalued. Furthermore there would be zero arbitrage opportunities (taking advantage of a price difference between two or more markets). But let’s look at some examples of a few market inefficiencies.

1. The 2000 – 2002 financial crisis. Things were going so well in the stock market before 2000. The market was reaching new highs and people were making money. But of course we know that the market was grossly overvalued at this point. By believing in this idea that markets are efficient, financial leaders were inconsiderate to the chronic underestimation of the dangers of asset bubbles breaking. This inevitably led to one of our great recessions as the market corrected itself.

2. Lululemon at its current price of around $60 is disgustingly overvalued. It is currently trading at over 60X what it is earning. Meaning that for every dollar you put into it you will earn, as an owner of the business (in theory), less than two cents on that dollar. Even its price to book ratio is huge at about 20X, meaning that even if the company liquidated for every dollar that you put into it right now you would only get back about five cents! Now don’t get me wrong Lululemon is an amazing company, but the current price that some people are buying into it at right now is extremely overvalued. Its prospects and growth don’t even justify a price this high! Even the average price to earnings ratio for the industry is only about 27X!! So even if we use this average (although this is still very overvalued) it should be trading at about $25. But in my opinion that is still too high. $15 or $20 would be more understandable. There is no safety of principle with Lululemon at its current price, and if the market were efficient, the price of Lululemons stock would be much lower. (Please note that when I originally wrote this Lulu was trading at about $120, however recently they did a stock split so the share price is halved. The ratios are the same however.

3. China Linen Textile Industry at its current price of around 2.25 is disgustingly UNDERvalued. The company sells linen and yarn in China, and has both excellent management and fantastic prospects. What is more interesting to note is that it should be trading at about $18.00 based on some calculations that I have done (I also strongly urge everyone to check these guys out). Its current EPS for the first quarter of 2011 was a whopping $0.44! We can also safely assume that this number will continue in subsequent quarters, as their business is not cyclical or seasonal, meaning they should finish the year with an EPS of about 1.86. That means the P/E ratio is only 1.3X! This means that if you were to buy today you would make back (as an owner) more than half of your initial investment in one year. Furthermore, the company is poised for growth, as it plans to take over other companies in the surrounding area, and also receives some unique help from the Chinese government (again, check these guys out). So why the price discrepancy? Who knows?! The point here is that the market is not efficient. If it were, this company would be trading at a price much higher than what it is currently trading at.

So there are three examples on how the market is not efficient. Obviously we would need only one to disprove this assumption, but three really drives the point home. And of course there are many other examples out there, but we’ll stick with these ones for now.

Strike two MPT. The second assumption that the market is efficient does not stand up for modern portfolio theory to work.

“Here batter batter! Swing batter batter!”

MPT – Strike Three: Investing Is A Trade-Off Between Risk And Expected Return
Now here is where I start to get a little frustrated. You might even say that I get a little pissed off. This is less of an assumption of MPT but rather a STATEMENT that really brings the whole structure of what the model intends to do to its knees. The statement proposed by MPT is that……………

INVESTING ISSSS A TRADE-OFF BETWEEN RISK AANNDD EXPECTEDDD REEETUUUURNN
It is saying that the higher the risk, the higher return. Remember when you were a little kid watching cartoons and when the characters got so angry that steam came out their ears? That’s me when I read that statement.

That statement is so far from the truth that I find it appalling that institutional investors actually say that. Investing is NOT a trade-off between risk and expected return. In fact the opposite is true. Stocks and portfolios with lower risk tend to provide higher returns than stocks and portfolios that carry higher risk. And if any investor or financial advisor tells you anything different, do not give them a single penny! Just stand up, and politely leave. They have no idea what they are talking about.

Furthermore, let’s clear up what risk is defined as in the stock market. “Risk is based on the amount of research one is willing to put into ones portfolio.” And, ultimately, the higher the price paid for a stock, the higher the risk. Investors who gamble in the stock market are not investors; they are gamblers. So please do not confuse risk in the stock market with anything else that is outside of what I have just stated.

I would also like to point out here what the actual definition of investing is: “Investing is allocating capital into an operation that provides a safety of principle (your money) while providing an adequate return.”

But let’s get back to the point. Let’s look at how this statement is far from true, and how MPT is seriously flawed in stating this.

It is actually very easy to prove how this point is flawed. All I would need to look at is the fund with the lowest possible risk and compare it with ANY other fund that offered even slightly higher risk (which would be all of them). It has been shown that over any large time period, lower risk funds actually produce greater gains than higher risk funds. The lowest risk funds in history are the index funds; the S&P 500, the DJIA, the Nasdaq, and the rest. Unsurprisingly, they outperform the vast majority of high risk funds over any large time period (5-10 years).

Taking large time periods into account, lower risk mutual funds only return (on average) between 2.5% and 3.7% annually, with the higher risk portfolios generating only 0.2% per year! If we even take a look at the performance of mutual funds just over the last year we find that the average return was only about 1%! If anyone can show me a high risk fund that has outperformed the market over a 10 year span I would love to hear from you.

So when does the higher risk pay off? I mean, with higher risk there should eventually be higher reward right? Well, obviously not. There can be the POTENTIAL for higher returns with higher risk in the short run, but nothing more. Even saying this we would be speculating a great deal, as some investors have a vastly different definition of risk than what we should use (other financial institutions assign a level of risk based on the standard deviation of the historical returns or average returns of a specific investment).

But, I guess the statement isn’t totally untrue. There is a trade-off between risk and expected return, but in the opposite way that you would think. Lower risk will often produce higher returns. But the statement that MPT assumes to be true is false. So again, there is evidence to dismiss the modern portfolio theory.
“Strike three! Yerrr ooutttt!”

MPT – Conclusion

MPT is a seriously flawed model based on a few large assumptions that are not necessarily true. Investors are not rational, the market is not efficient, and investing is NOT a trade-off between risk and expected return, where higher risks are associated with higher returns.

It is a mathematical model used by the majority of financial institutions to justify some of the absurd investments they invest in (and try to get others to invest in) and the investment strategies that they use. The only true way to invest is by using a value oriented approach to investing.

However I must give thanks to the modern portfolio theory, as it has increased the amount of mistakes that the financial industry makes, and may have been a cause of the recession in 2008. So why am I thanking people who use MPT? Because it creates excellent buying opportunities for people like me. Stocks were so cheap at that time you could have bought into almost any company at a discount. And that is how a real investor makes money, by buying into something that provides a margin of safety.

I hope you all enjoyed my take on modern portfolio theory and I strongly encourage everyone to check out China Linen Textile Industry LTD. And feel free to follow me on twitter at JustinG101!
 

Hotch

Experienced member
1,410 256
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scose-no-doubt

Veteren member
4,630 954
Well considering it's used more as a framework than a set of dogmatic rules I don't really see the reason for all the palaver.

Why don't you try coming up with an alternative?
 

Justo22

Junior member
14 1
What is your point, Justin? Apart from beating a dead horse?

My point is that the model doesn't work. I know it's a long one, but I'd rather showcase how it doesn't work by providing some examples rather than just make wild accusations. I mean, this theory is still used by many financial institutions right? And if that is the case then they should know the workings of thier own theory don't you think? :)
 

Justo22

Junior member
14 1
Well considering it's used more as a framework than a set of dogmatic rules I don't really see the reason for all the palaver.

Why don't you try coming up with an alternative?

Haha ok yes I understand it was a long one. I just thought it was an interesting piece of writing. But thank you for the feedback. If I was to suggest an alternative off the top of my head it would be to use a value oriented approach to investing. And for those who relly don't want to lose any money diversify a little bit.

What would you suggest? I'd love to hear a different side or another opinion. :)
 

Martinghoul

Senior member
2,690 276
My point is that the model doesn't work. I know it's a long one, but I'd rather showcase how it doesn't work by providing some examples rather than just make wild accusations. I mean, this theory is still used by many financial institutions right? And if that is the case then they should know the workings of thier own theory don't you think? :)
Well, listen, with all due respect, your critique of MPT is very poor. If you want me to delve into why that is, I would be happy to.

As to the modern use of MPT, yes, it is used in a variety of ways, but everyone who uses it is aware of its limitations. They also know it intimately and, I suspect, a lot better than you think you know it. Again, I mean no offense, but I just think it's not wise to start with an assumption that you're the smartest guy around and have a level of understanding that exceeds that of the practitioners who have been doing it for a long long time. For me humility is always the starting point.
 
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Justo22

Junior member
14 1
Well, listen, with all due respect, your critique of MPT is very poor. If you want me to delve into why that is, I would be happy to.

As to the modern use of MPT, yes, it is used in a variety of ways, but everyone who uses it is aware of its limitations. They also know it intimately and, I suspect, a lot better than you think you know it. Again, I mean no offense, but I just think it's not wise to start with an assumption that you're the smartest guy around and have a level of understanding that exceeds that of the practitioners who have been doing it for a long long time. For me humility is always the starting point.

I take no offense at all I love the discussion. Yes you are probably correct in saying that I do not know the deeper workings of the theory than someone who studies it in great depth. However the assumptions that it uses (which are far greater than the ones I have pointed out here) add too much risk to the theory and the model. And I apologize if I came across as a know-it-all that was not my intention. :) As far as the theory goes though, the level of understanding needed to disprove the theory is minimal.

If you could delve into how my critique is poor I would greatly apreciate it. :)
 

Martinghoul

Senior member
2,690 276
I take no offense at all I love the discussion. Yes you are probably correct in saying that I do not know the deeper workings of the theory than someone who studies it in great depth. However the assumptions that it uses (which are far greater than the ones I have pointed out here) add too much risk to the theory and the model. And I apologize if I came across as a know-it-all that was not my intention. :) As far as the theory goes though, the level of understanding needed to disprove the theory is minimal.

If you could delve into how my critique is poor I would greatly apreciate it. :)
No worries... I am also happy to discuss.

As I said, I think you're barking up the wrong tree. MPT, like any other theory, is not guaranteed to be correct in every respect. All theories are stylized representations of reality based on a variety of simplifying assumptions. In spite of being stylized, they offer a self-consistent analytical framework that can be used to obtain insights into some aspects of how things work out there in the real world. Practitioners use a given theory, adjusting and compensating for all its imperfections. At the same time, academics keep trying to poke holes in the theory, until they find a better one, at which point practitioners switch over. This is a sequence that is repeated in pretty much all sciences, not just economics and finance.

As to the MPT, yeah, it's based on a variety of unrealistic assumptions. Good practitioners (e.g. traders, risk managers, etc) know about them and should be able to compensate (for which they get paid). Good academics (e.g. behavioural economists) have been offering meaningful critiques of MPT for a while and have even come up with some alternatives, although none are universally accepted yet. In spite of all of the above, MPT is still a good basic framework, just like, for example, Black-Scholes or Newtonian mechanics.

As to your actual examples, specific cases that you offer don't actually disprove the assumptions of MPT. Bounded rationality of investors isn't disproved by the existence of Jim Cramer. P/E ratios and your opinions on company valuations don't disprove market efficiency. Finally, in terms of the risk - return tradeoff, you're simply confused by the difference between the expected return and the realized return. Moreover, your definition of risk is wrong.
 

cr6196

Well-known member
444 76
Pretty concise answer there MH. I must say I have been trying to get up to date with the research here and any1 who thinks its as simple as markets are efficient/investors are rational is crazy. there is difference between something being absolutely wrong and mostly right.

also I would say the general tools and ideas are really useful. a lot of the biggest funds (DFA, LSV, AQR) employ these people. Your general idea of MPT seems to be stuck in the 60s, you should check out some of the more recent stuff. its tough but worth it. the other thing is china linen isn't a great stock. making mistakes is fine but the problem comes when you mistake your lack of knowledge for a lack of contradictory evidence. know what you don't know, which with companies like china linen is basically everything (that should be enough of a hint).
 
 
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