Modern Portfolio Theory

There are many who use the Modern Portfolio Theory (MPT) ideas without the techniques.  There are some who think it is an elegant and internally consistent mathematical diversion.  Here are two thoughts I came on within an hour of each other.

What do these inventions have in common?

  1. KFC’s first franchise
  2. Modern Portfolio Theory
  3. The first treadmill
  4. The first diet soda
  5. The first video recorder

All came into the world in 1952.  Now he interesting question.  Which of them has never changed?

Modern Portfolio Theory.  I suppose a 64 year old theory may not be fully modern, but who is noticing.  You can find more here.

The second point was raised by Charlie Munger.

Charlie never hears the question, “But what do you really think?”  This example, when he was asked whether it’s worth going to business school:

“You pay $30,000 a year to learn that you should not value assets, as the market values them for you.  If people were not so often wrong, we would not be so rich.”

Vitaliy Katsenelson offers an explanation of why MPT persists.

Personally, I have a theory that the reason schools still teach MPT is that it’s teachable. Let’s say you’re a dean and you have an investment class that needs to be taught. You can try to bring in a practitioner to teach this class, but not all good practitioners are good teachers. But with MPT you can take a physics or statistics professor — anyone who is good with formulas and numbers — give them a book, and in a few days they’ll be MPT and investment experts.

MPT is taught despite all its flaws because it is elegantly laid out in simple formulas that are all wonderfully interconnected. Also, it employs lots of Greek symbols and thus glows with an air of scientific sophistication. On the other hand, the real-world investing that is practiced by Buffett and Munger is full of common sense but very difficult to express in precise formulas. It is fuzzy and ambiguous. Try to teach that in the classroom!

I like mathematical elegance but it behooves us to always ask whether the elegance includes a tight connection to reality.  Munger believes it is not connected and there is little evidence to make him wrong.  Katsenelson believes that instinct and feel are hard to teach so no one tries.  The results are uneven.

MPT appears to be an example of the life rule

“For every problem there is a solution that is simple, attractive and wrong”  Arthur C. Clarke

Value investors avoid the wrong answer as best they can and tend to consistently outperform the market over the intermediate run and longer.  Why is that so?

Most of them think that business valuation and market value are only slightly connected in the short run with the connection becoming tighter as time passes.  Common sense seems to perform better than does a mathematical model.  In any case, all of them understand both business valuation and market pricing methods.

Paradoxiacally, MPT is a part of their success.  Charlie Munger again.

“Competency is a relative concept. When I started, what I needed to get ahead was to be better than idiots and, lucky for me, there were a lot of them.”

The “idiots” were likely not intellectually challenged, but they believed in a theory that was antithetical to common sense.  When they acted on it they tended to lose.

You need not repeat their mistake.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.  In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you.  don@moneyfyi.com  866-285-7772

This entry was posted in Investing, Personal Finance and tagged , , . Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s