The Power To Perform: mhj3.com Managing Investing Judgment Since 1989

Investing Fool's Tool #1: Mindless Modern Portfolio Theory
Mindless, felony stupid investment advising comfort food

Home | Beta Baloney | Efficient Frontier Analysis | Pie Charts | Monte Carlo Analysis | Brinson's Asset Allocation | Technical Analysis | MPT Risk Management | Dull Sharpe Ratio | MPT Investment Planning Software | Modern Portfolio Theory.mp3

Investment Advisors and Individual Investors

Many investment advisors and individual investors have not taken the time to learn that though the academic concepts of Modern Portfolio Theory may seem to help them to select investments, Modern Portfolio Theory does not actually work.

We all want to know and to be able to project the security of, the risks of, and the potential for investments as the financial markets change.

We all want to know what the optimum investment composition would be for the most efficient investment portfolio under given/projected investment conditions; the simpler the method, the better.

Along came 'simple;' Modern Portfolio Theory — mindless investment advising and investing performance comfort food.

Wall Street

Wall Street jumped on the Modern Portfolio Theory bandwagon.

What could be better than the vacuous, brain-numbing combination of Modern Portfolio Theory and pie chart, graph, and data dump infested investment plans to mesmerize the investing unsuspecting?

Investment Advisors and Stockbrokers

Legions of investment advisors and stockbrokers, thirsting for 'paint by the numbers' investment advising methods and means for providing investment advice, glommed onto this investing farce; 'causing' the current devolving state of the profession of investment advising.

The appeal of Modern Portfolio Theory to investment advisors and stockbrokers is its simplicity, graphic presentation value, and most of all, little or no investing judgment or skill is required; just scan, sort, pick, retrieve, view, print, present, and hope that the investing past will somehow become the investing future.

Albert Einstein

Historically, Albert Einstein, as quoted from "Einstein, His Life and Universe," by Walter Isaacson, embraced Spinoza's Determinism; a sense that the laws of nature, once we could fathom them, decreed immutable causes and effects and that God did not play dice by allowing any events to be random or undetermined.

Einstein "became more and more convinced that nature could be understood as a relatively simple mathematical structure."

Einstein, certain of strict, predicable causality in nature, knew that math was "the language nature uses to describe her wonders."

Einstein's ability to systematize (identify the laws that govern a system) enabled him to "tie together all of nature's forces" to define and separate immutable relationships between causes and effects to predict, with certainty, outcomes.

Modern Investing Math Mystique

There is an ever increasing and unexplainable modern investing math mystique investing equation phenomenon; if what seems to be or is defined to be a cause and effect occurrence expressed as a mathematical equation, the equation is assumed to be, must be valid, universally true, and has unique predictive powers.

'Einstein's theory of relativity seems to be valid:'

'Certainly If is valid and reflective of actual cause and effect variable relationships and is, therefore, predictive of behaviors in the universe, then surely the latest iteration of the Beta risk measurement equation below — much more complex, with many more variables than Einstein's equation — most certainly, must be, just has to be valid.'

From:

Beta = [Cov(r, Km)] / [StdDev(Km)]2

To:

'Wow, look at this one, honey.''It just has to work!' 'Let's put all of our life savings into this equation!'

Well, it doesn't.

Regrettably, mathematicians concluded that since Einstein's simple math works in the universe to explain current natural phenomena and to predict future relationships and events, it most certainly will work in the sublime chaos of the financial markets.

Mathematicians

A few Albert Einstein mathematician wantabes, while ignoring the obvious structural and causality differences between the universe of nature and the universe of the financial markets, extracted the laws and concepts of Einstein's universe, so to speak, and attempted to superimpose them, in effect, onto the world of investing by confusing, comparing, and applying the concepts of immutable order, structure, relationships, causes, connections, correlations, effects, and rules (Newton's three Laws of Motion, for example) as found in the sciences and systems of the universe and as explained with mathematics with the chaos, incidences, coincidences, chances, correlations (none of which are causal; but, assumed in order to make Modern Portfolio Theory math work) and no rules as found in the artistry and complexity of investing and managing capital in the financial markets in an effort to predict investment outcomes; the ultimate 'non sequitur' of investing.

Modern Portfolio Theory (Investopedia)

Modern Portfolio Theory starts with the idea that individual investment contains two types of risk:

  • Systematic Risk — These are market risks that cannot be diversified away. Interest rates, recessions and wars are examples of systematic risks.
  • Unsystematic Risk Also known as "specific risk," this risk is specific to individual stocks and can be diversified away as the investor increases the number of stocks in his or her portfolio. In more technical terms, it represents the component of a stock's return that is not correlated with general market moves.

Modern portfolio theory shows that unsystematic/specific risk can be removed through diversification.

The trouble is that diversification still doesn't solve the problem of systematic risk; even a portfolio of all the shares in the stock market can't eliminate that risk.

For a well-diversified portfolio, the risk — or average deviation from the mean — of each stock contributes little to portfolio risk.

Instead, it is the difference — or covariance — between individual stock's levels of risk that determines overall portfolio risk.

  • This can be seen intuitively because different types of assets often change in value in the same or opposite ways.

As a result, investors benefit from holding diversified portfolios instead of individual stocks.


Modern Portfolio Theory Investing Contradictions

There are empirical investing contradictions to keep in mind when evaluating the merits — or should I say demerits — of Modern Portfolio Theory.

Conceptually, Modern Portfolio Theory seems logical — diversification reduces investing risks; however, from a practical perspective, Modern Portfolio Theory is of no investing performance value because the calculation variables and assumptions — Standard Deviation, Mean, Beta, Risk, Expected Return, Risk-Free Rate, Expected Market Return, Equity Market Premium — are all based on self-serving assumptions (to semingly make Modern Portfolio Theory work) and past investment performance.

Investing experience and investing law tell us that past investment performance is not an indicator of future investment results; as anyone who has spent more than a nanosecond in the financial markets would or should know.

Yet modern Portfolio Theory and all of its illegitimate relatives — Monte Carlo Analysis, Efficient Frontier Analysis, Beta, Alpha, Optimizers, and, even a distant relative, Investing Technical Analysis — all use past performance to predict future investment results!

Past Performance

Past investment performance is not an indicator of future investment results' is a required, responsible, and absolutely true investing footnote, an investing fact that anyone who has spent more than a nanosecond in the financial markets would or should know, and an investing law designed to protect the investing naive, innocent, and unsuspecting:

  • Past performance is not only not a guarantee of future investment results, it ,other than a possible reference point, has little to do with it.
    • If they could have, the 'imagineers' of Modern Portfolio Theory would have had Vincent van Gogh paint and Leonardo da Vinci sculpt by the numbers.

Then why would one blindly place his/her trust in the present and his/her hope for the future in a mythical investing science — Modern Portfolio Theory and all of its illegitimate relatives such as Monte Carlo Analysis, Efficient Frontier Analysis, Beta, Brinson's Asset Allocation, Pie Charts, and a distant relative, Technical Analysis (worth a glance) that relies solely on past performance investment data to feed hypothetical and contrived investing algorithms in a misguided effort to predict future investment results?

All are just other ways to record and to illustrate investment history without valid analytical, interpretive, deductive, predictive, or directional investment value.

If this nonsense were valid, there would be no need for investing analytics, forecasting, or guidance of any kind — research, analysis, opinion, advisors — and one would simply select investments based on past performance without regard to suitability, quality, structure, or risk.

Explained another way, a thermometer measures temperatures in degrees as the weather changes.

A thermometer is a recording device not a forecasting one and, therefore, it cannot be used to predict future temperature levels.

Standard Deviation, Efficient Frontier, Beta, VaR, and Sharpe Ratio are much like a thermometer; merely means to measure past (contrived) relative investment performances between investment variables and neither the cause of nor the predictor of either.

Furthermore, if a thermometer also happened to store prior temperature readings on a daily basis, you certainly would not retrieve that information and use it to predict tomorrow's or next week's temperature readings.

As one would have to analyze the weather-changing causal variables that affect weather, such as humidity and barometric pressure, to predict future temperature levels.

The same holds true for historical Standard Deviation, Efficient Frontier, Beta, VaR, and Sharpe Ratio readings as a basis for predicting the investing future.

Future investment values and associated investment/investing risks can only be meaningfully understood and predicted based on one’s correct understanding and interpretation of the fundamental performance changing, causal investment performance variables that actually affect an equity’s behavior.

Keep in mind, there is no theory — modern or otherwise — that can be ordained, no computer that can be programmed, no software that can be designed, no investing tool that can be 'imagineered,' no technical analysis voodoo methodology that can be contrived, and no equation that can be divined to quantify, evaluate, and predict the primary forces that drive the sublime chaos of the financial markets and investment prices; human consensus, mood, and behavior; intelligent and not, knowledgeable and not, reasoned and not, rational and not, and logical and not.

Modern Portfolio Theory Conclusions

Modern Portfolio Theory, the Olestra™ of advising and investing, using yesterday's news as an investing crutch, is but another way to record and to illustrate investing history without valid analytical, interpretive, deductive, predictive, or directional investing value because it assumes and suggests, incorrectly, that the financial markets' cycles of the past and the valuations of underlying investments in the past — because they are somehow mysteriously connected as part of an orderly, sequential financial system — will repeat themselves similarly or exactly in the future as they did in the past in much the same order and with the same frequencies, sequences, durations, levels, relative valuations, and volatilities; thus, brining a new and painful meaning of attempting, and regrettably succeeding in the eyes of many, to 'force a square peg into a round hole.'

At the end of the day, a portfolio's success rests on the investment advisor's and individual investor's skills and the time he or she devotes to developing those skills.

Bottom Line

Modern Portfolio Theory investing hindsight is neither investing insight nor investing foresight.

History will show that Modern Portfolio Theory is an investing hoax and that it did for investing what peanut butter and jelly sandwiches did for medicine.