Katsenelson: The Modern Portfolio Theory Flat Earth Society

Flat EarthI like reading Vitaliy Katsenelson’s work. Though I don’t always agree, he’s a unique author among the many who call themselves so in the industry. Seeing the title of his latest piece, I was immediately drawn to it.

Excerpts from Katsenelson’s May 14th Article titled:

The Modern Portfolio Theory Flat Earth Society

“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.

The opening paragraph represents a view that is not on display in the financial services industry. The industry would like you to believe that the world of finance can easily be described by equations, this thinking led to the financial crisis. At the heart of many of these equations is a number we know as “beta.”

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 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.

I once thought the exact same way, until the financial crisis happened and until I spent six months immersed in the course work.

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 studied for it in the very recent past, it hasn’t changed and in fact has moved further down the MPT road.

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.

MPT is a great equation, it just doesn’t work. I would take issue with the use of the Dalbar study, I’m not sure it’s as accurate as many think.

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.

I would argue the opposite, this theory is used by many in the money management industry, especially many of the so-called Robo-Advisors (who tout it as the engine of their models).

Imagine you are living in the Dark Ages and the Greeks already proved that the world is round, but 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.

Correct, except many real-world professionals also adhere to this theory religiously. They worship at the alter of MPT and efficient markets.

If you learn anything by going to the Berkshire Hathaway annual meeting, it is the incredible power of incentives. Berkshire vice chairman Charlie Munger 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.

I was indoctrinated into MPT early in my financial services education and am still trying to extricate myself!

You can read the entire post here.

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