Fw: The Modern Portfolio Theory Flat Earth Society (possible duplicate)

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From: Vitaliy Katsenelson <vk@imausa.com>

Date: Sat, 29 Nov 2014 17:11:37 -0500

To: Bob<mainandwall@gmail.com>

Subject: The Modern Portfolio Theory Flat Earth Society (possible duplicate)

If you have subscriber's remorse and would like to unsubscribe, just click here - no hard feelings, and this will be the last email packed with my in Like   Tweet   +1   Forward   Unsubscribe      If you have subscriber's remorse and would like to unsubscribe, just click here - no hard feelings, and this will be the last email packed with my infinite wisdom you will receive. - Vitaliy This oil painting "Samba" is by father Naum Katsenelson 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. 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. 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've been in the investment industry for almost 20 years. I have had thousands of conversations with other investors about stocks, but I have yet to have one conversation in which beta or Modern Portfolio Theory was mentioned as part of the analytical framework — not even once. You hear MPT and beta in the same sentence with other words such as "useless," "theoretical" and "garbage." If you were to ask what the beta of any company in my portfolio is, I would have no answer for you; I have simply never looked. But ask me about the return on capital or debt of any stock in the portfolio, and I'll be right in the ballpark. 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. 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. Imagine you are living in the 16th century. Nicolaus Copernicus has already more or less proved that the world is round, but the new textbooks have not yet come out, and 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. 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. P.S. Today I wanted to share with you a composition from "Side by Side" a 1994 recording of Oscar Peterson (piano) playing together with one and only Itzhak Perlman (violin) (listen to it here). I think owned this CD recording for twenty years (for all young fellows out there reading this, it is a great CD to impress girls, a side from the fact that it is wonderful music). While looking for this piece I stumbled on a wonderful concert recorded in 1980 – Oscar Peterson (piano), Joe Pass (guitar), and Count Basie (piano). (listen to it here). If you believe your friends, enemies, relatives or random strangers accumulated a seven figure portfolio and will benefit from our investment services, call Theresa at (303) 796-8333 and we'll be happy to mail them a signed copy of The Little Book of Sideways Markets. Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy's future articles by email or read his articles click here. Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy's book Active Value Investing (Wiley, 2007).    © 2014 IMA | Investment Management Associates, Inc. 5690 DTC Blvd, 140W Greenwood Village, CO 80111 Phone 303.796.8333 Forward   Unsubscribe     Powered by Mad Mimi ®