The Absurdity of Modern Portfolio Theory Part 3

Discussion in 'Risk Management' started by Justo, Jul 20, 2011.

  1. Justo


    MPT – Strike Three: Investing Is A Trade-Off Between Risk And Expected Return
    Now here is where I start to get a little frustrated. You might even say that I get a little pissed off. This is less of an assumption of MPT but rather a STATEMENT that really brings the whole structure of what the model intends to do to its knees. The statement proposed by MPT is that……………..
    It is saying that the higher the risk, the higher return. Remember when you were a little kid watching cartoons and when the characters got so angry that steam came out their ears? That’s me when I read that statement.
    That statement is so far from the truth that I find it appalling that institutional investors actually say that. Investing is NOT a trade-off between risk and expected return. In fact the opposite is true. Stocks and portfolios with lower risk tend to provide higher returns than stocks and portfolios that carry higher risk. And if any investor or financial advisor tells you anything different, do not give them a single penny! Just stand up, and politely leave. They have no idea what they are talking about.
    Furthermore, let’s clear up what risk is defined as in the stock market. “Risk is based on the amount of research one is willing to put into ones portfolio.” And, ultimately, the higher the price paid for a stock, the higher the risk. Investors who gamble in the stock market are not investors; they are gamblers. So please do not confuse risk in the stock market with anything else that is outside of what I have just stated.
    I would also like to point out here what the actual definition of investing is: “Investing is allocating capital into an operation that provides a safety of principle (your money) while providing an adequate return.”
    But let’s get back to the point. Let’s look at how this statement is far from true, and how MPT is seriously flawed in stating this.
    It is actually very easy to prove how this point is flawed. All I would need to look at is the fund with the lowest possible risk and compare it with ANY other fund that offered even slightly higher risk (which would be all of them). It has been shown that over any large time period, lower risk funds actually produce greater gains than higher risk funds. The lowest risk funds in history are the index funds; the S&P 500, the DJIA, the Nasdaq, and the rest. Unsurprisingly, they outperform the vast majority of high risk funds over any large time period (5-10 years).
    Taking large time periods into account, lower risk mutual funds only return (on average) between 2.5% and 3.7% annually, with the higher risk portfolios generating only 0.2% per year! If we even take a look at the performance of mutual funds just over the last year we find that the average return was only about 1%! If anyone can show me a high risk fund that has outperformed the market over a 10 year span I would love to hear from you.
    So when does the higher risk pay off? I mean, with higher risk there should eventually be higher reward right? Well, obviously not. There can be the POTENTIAL for higher returns with higher risk in the short run, but nothing more. Even saying this we would be speculating a great deal, as some investors have a vastly different definition of risk than what we should use (other financial institutions assign a level of risk based on the standard deviation of the historical returns or average returns of a specific investment).
    But, I guess the statement isn’t totally untrue. There is a trade-off between risk and expected return, but in the opposite way that you would think. Lower risk will often produce higher returns. But the statement that MPT assumes to be true is false. So again, there is evidence to dismiss the modern portfolio theory.
    “Strike three! Yerrr ooutttt!”
    MPT – Conclusion
    MPT is a seriously flawed model based on a few large assumptions that are not necessarily true. Investors are not rational, the market is not efficient, and investing is NOT a trade-off between risk and expected return, where higher risks are associated with higher returns.
    It is a mathematical model used by the majority of financial institutions to justify some of the absurd investments they invest in (and try to get others to invest in) and the investment strategies that they use. The only true way to invest is by using a value oriented approach to investing.
    However I must give thanks to the modern portfolio theory, as it has increased the amount of mistakes that the financial industry makes, and may have been a cause of the recession in 2008. So why am I thanking people who use MPT? Because it creates excellent buying opportunities for people like me. Stocks were so cheap at that time you could have bought into almost any company at a discount. And that is how a real investor makes money, by buying into something that provides a margin of safety.
    I hope you all enjoyed my take on modern portfolio theory and I strongly encourage everyone to check out China Linen Textile Industry LTD. And feel free to follow me on twitter at JustinG101!