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

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Modern Portfolio Theory.mp3

Think about it: '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.

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.

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 investing 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.

Mathematicians

Mathematicians concluded that since Einstein's math works in the universe to predict future events, it most certainly will work in the financial markets.

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

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 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 is 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

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 past investment performance.

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

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 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.

Modern Portfolio Theory Conclusion

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..

Beta

Beta is simply a contrived comparison of the changing relationships between two coincidentally related stock market related variables; measuring the volatility (sensitivity) of an investment in relationship to a selected market index as the financial markets change.

Beta, like a thermometer, is merely a recording device; a means of recording past relative investment performance relationships between two investment variables and neither the cause of either nor a predictor of a future beta; the temperature is/was 80 degrees the Beta is/was 2; nothing more.

If it had rained for the last three days, you would not conclude that it will rain today or tomorrow because it had rained for the last three days.

  • The probability and prediction of rain, its duration, and the amounts would properly be projected based on the presence, combinations, and levels of rain causing variables.

You would not say, you must not say — though it is said everyday — that an investment portfolio has low investment risk because the betas of underlying investments are low; beyond felony stupid.

  • The probability and prediction of the direction and duration of the stock market and investment prices and the degree of investment risk would properly be based on the variables that cause market valuation and investment price changes and that determine investment risk; the fundamentals and value of the economy and the fundamentals and value of individual companies; not stock market history and investment price history thrown into beta equations.

Efficient Frontier

The Efficient Frontier is the line on a risk-reward graph comprised of all efficient investment portfolios; portfolios that provide the greatest expected return for a given level of risk or, for any expected return, the ones that will have the least volatility. 

 

Efficient Frontier

 

 

All portfolios on the vertical dotted line above have the same risk. Of all the portfolios for a specific level of risk, such as the portfolio represented by the blue square at the intercept of the vertical and horizontal dotted blue lines, offers the greatest expected return for that level of investment risk; therefore, all portfolios for that level of investment risk that are below the blue square must be changed to the most efficient portfolio; the blue square, the Optimum Portfolio.

 

Wow, that was easy! So that is all there is to investing?

I can here it now:

'My investment advisor said that the investments he is recommending did well in the past (he said that's why he picked them) and so they should do well for us in the future.

When we review our account with him, if updated, Efficient Frontier Analysis historical investment performance data indicates that we might do better if we were to sell our current investments that were selected based on an earlier Efficient Frontier Analysis, we will have several options:

  • We will sell those investments that are up, but have not done as well as other investments in the recent past, and buy new investments that are like ours but that have done better than ours in the recent past.
  • If any of our current investments are down and have not done as well as other investments that are like ours since the last review, we will sell those investments that have done poorly in the recent past and move to investments that have done better than ours in the recent past.

Apparently, if we keep taking losses on our investments that are down, keep making these changes on a regular basis, and keep buying new investments that have done better than our investments that are down in the recent past, we will eventually have investments that will do well for us in the future; that is until we sell them to buy other investments that have done better than ours in the recent past.

At any time in the future, when the efficient frontier data dots reverse positions, he will contact us to go back to where we were.'

Regrettably, to compound the travesty of their conclusions, Modern Portfolio Theory was awarded a Nobel Prize.


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.

CAPM*

Pronounced as though it were spelled "cap-m", this model was originally developed in 1952 by Harry Markowitz and fine-tuned over a decade later by others, including William Sharpe as set out in his 1970 book "Portfolio Theory And Capital Markets".*

This model presents a very simple theory that delivers a simple result.

The theory says that the only reason an investor should earn more, on average, by investing in one stock rather than another is that one stock is riskier.

His model 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 stocks return that is not correlated with general market moves.

Modern Portfolio Theory shows that 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. Therefore, when calculating a deserved return, systematic risk is what plagues investors most. CAPM, therefore, evolved as a way to measure this systematic risk.

The capital asset pricing model (CAPM) describes the relationship between risk and expected return, and it serves as a model for the pricing of risky securities. CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat our required return, the investment should not be undertaken.

Here is the formula:

A translation of the above would be as follows: Required (or expected) Return = RF Rate + (Market Return - RF Rate)*Beta

For example, let's say that the current risk free-rate is 5%, and the S&P 500 is expected to return to 12% next year. You are interested in determining the required rate of return of Joe's Oyster Bar Inc.

You have determined that its beta value is 1.9. The overall stock market has a beta of 1.0, so Joe's Oyster Bar Inc. beta of 1.9 tells us that it carries more risk than the overall market; this extra risk means that we should expect a higher potential return than the 12% of the S&P 500. We can calculate this as the following:

  • Required (or expected) Return = 5% + (12% - 5%)*1.9
  • Required (or expected) Return = 18.3%

What CAPM tells us is that Joe's Oyster Bar has a required rate of return of 18.3%. So, if you invest in JOB, you should be getting at least 18.3% return on your investment. If you don't think that JOB will produce those kinds of returns for you, then you should consider investing in a different company.

If one were to concede that the concept of CAPM seems to make sense, then it would only have value if it has practical application in determining the Required (or expected) Return as determined by the variables used in its calculation; RF Rate, Market Return, Market Beta, and Investment Beta.

Variable valuation is the beginning of the end for the value of CAPM:

  • The Current RF Rate is known; tomorrow's and the future's RF Rate is not.
  • The S&P 500 expected return X% next year is absolutely nothing more than speculation.
  • The determination of an investment's Beta, by definition and calculation, is based on the historical relationship of the unconnected, unrelated variables -except for the convenience of trying to force a square peg into a round hole- used to calculate Beta and there is no basis whatsoever for concluding that yesterday's Beta will be tomorrow's or the future's Beta.
  • The overall stock market has a beta of 1.0 by definition.

You can generate any answer you want based on the assumptions/guesses you make about the variables; three variable valuation guesses and one fixed variable input used in a formula where there is no fixed relationship between the variables other than by definition as defined by the developer of the theory does not a Noble Prize Worthy Theory make!

*CAPM definition, variables, and formula as summarized from Financial Concepts: Capital Asset Pricing Model (CAPM).