Is Modern Portfolio Theory Harming Your Portfolio?

Economics versus finance.

July 31, 2011

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1023138_warning_icon_6If, like Warren Buffet, you think ‘diversification is protection against ignorance,’ then you have to read Scott Vincent’s recent manifesto on the merits of human judgment in investment decision-making (and the costs and consequences of the outbreak of modern portfolio theory in the investment management industry).

Vincent’s paper is entitled, “Is Portfolio Theory Harming Your Portfolio?”, and I think it is awesome. Why? Because he makes a profound argument in favor of economic geography and the geography of finance (though he may not totally know it). In short, he makes a passionate case for the impact of “local knowledge” on positive long-term risk adjusted returns. Here’s a blurb:

“There’s compelling evidence that the core theories behind the push to passive management do not work…they worked well in a laboratory where the environment around them could be perfectly controlled, but when put into practice the theories’ underlying assumptions and logic didn’t translate.

He’s talking about the core theories underpinning Modern Portfolio Theory (i.e., CAPM, EMH, and Portfolio Selection), which have driven many investors into passive, highly diversified strategies. The idea has been to minimize firm specific exposure to maximize risk adjusted return (as defined by MPT). Interestingly, these theories do not grasp the complexities (and inefficiencies) of the real word. For example,

“While Markowitz’s theory has serious issues when applied to real life, Sharpe’s CAPM is in even worse shape. CAPM is built on the back of Markowitz’s theory so it starts with all of the baggage and incorrect assumptions and then adds more. Some of the doozies include an assumption that all investors could borrow and lend at the riskless rate and an assumption that investors all have identical views of expected correlations, returns, and risks…

The theories have become so deeply ingrained in our financial system that we can’t see their folly. Their mathematics, as well as the precise nature of their output, gives us a sense of comfort which is critical in deploying large sums of money. They also lead to a misallocation of resources, however, causing giant distortions…

While some argue that a system which works 99 percent of the time is good enough, these are the same people who would sell you a burglar alarm that works perfectly well until a would-be-criminal approaches your home. What good is a system that breaks down only when you most need it? See the financial crisis of 2008 or Long-Term Capital Management for a compelling answer. ”

It’s like the classic movie 28 Days Later but with MPT worshipping finance professionals substituted for rage infected monkeys. And, true to the apocalyptic movie, we’re still trying to quarantine the damage from the “outbreak” of MPT. Admittedly, that may be stretching things too far, but all this MPT bashing does have a point in Vincent’s paper; he is making a case for sophisticated active managers. And, in so doing, he starts with the world’s most successful active manager, Warren Buffet:

“We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.”

In other words, MPT gives investors a “pass” from having to actually understand the specific characteristics of what they are buying. But this, in turn, minimizes the ability of certain managers to actually generate returns. As Mr. Vincent notes,

“This argument turns CAPM on its head. A highly diversified, active manager cannot fully understand the risks he is taking on his positions so he may be paying too much for them, thus operating below the efficient frontier. While the concentrated manager is able to pick securities with an intimate understanding of their risk which helps him uncover assets whose prospective return more than compensates for the risk taken. The concentrated manager aims to buy assets that are beyond the efficient frontier.”

And, so, what should investors do about this?

“Take advantage of the fact that your neighbors are leaving for passive funds, as their passive investments could provide the inefficiency your manager seeks to exploit.”

In other words, the more money that’s being invested in accordance with “rational” models of finance, the more opportunities there will be for an informed trader (though not an inside trader) with asymmetric information to profit from being a bit “irrational”.

This post originally appeared on the Oxford SWF Project

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