MPT ¡V Strike 1: Investors Are Rational A friend of mine told me that I should look at the Modern Portfolio Theory (MPT) for some ideas on what to write about. Boy was he right. But first, what is MPT? MPT is a theory of investment which attempts to maximize a portfolio¡¦s expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. It is also a form of diversification (and you know how I feel about that (if not read my post on diversification)). MPT is best explained by using a mathematical model, which, in my own opinion, is a bunch of baloney. The only mathematics you need to evaluate companies or stocks is simple adding, subtracting, multiplication and division. That¡¦s it. Now the model works in theory, but in the real world, where there are no save points, it doesn¡¦t even come close to working. This is due to the FACT that it makes a few very grave assumptions. So part one of our journey through the pitfalls of MPT starts now with the assumption that¡K¡K¡K¡K. INVESTORS ARRRRRRRE RATIONAL One of the assumptions that enables MPT to work (in theory) is that investors are rational. I find great difficulty in believing this to be true due to the simple fact that investors are not any different from other people. Investors are people; plain and simple. Now how many people do you know who are completely rational? Take a few pauses here to really think about that¡K¡K¡K¡K¡Kkeep thinking¡K¡K¡K. Probably not that many right? And that is because the majority of people (please do not take offense here) are too emotionally driven to be rational. I know you¡¦re not though. ƺ So now how can investors be rational? Are they some sort of superior being that has evolved to totally abide by the rules of logic and circumstance and admonish most, if not all, of their emotionally weak mindset? Of course not. The majority of investors are not rational. They can be greedy, overzealous, and sometimes frightened when their favourite stock takes a plunge. As an example let¡¦s look back a few years at some irrational investors who were buying technology stocks. And remember any smart individual (who knows at least a little accounting) could see that the majority of ¡§tech¡¨ stocks were grossly overvalued at this time, even though they were very popular. 1. In 1999, Alexander Cheung of (what once was) Monument Internet Fund, after earning 117.3% in the first 5 months of the year, claimed that his fund would gain 50% over the next three to five years and would achieve an annual average of 35% over the next twenty years. Now is he rational? Well, considering most of the fund¡¦s portfolio was comprised of internet stocks which were grossly overvalued, I¡¦d say no he isn¡¦t rational. He got caught up in the market mayhem of internet stocks. Another point to look at is that the highest 20 year return for any mutual fund in history was about 25.8% per year (performed by the great Peter Lynch). Peter¡¦s performance during that period turned $10,000 into more than $982,000, and yet Cheung was saying that he could turn it into over $4,000,000! Obviously that is ridiculously overoptimistic. And here is the point¡K.investors bought it. These ¡§rational¡¨ investors threw more than $100,000,000 into Cheungs fund over the next year. By the end of 2002, that $100,000,000 was worth about $20,000,000. A loss of 80%. 2. Alberto Vilar of Amerindo Technology Fund, after a whopping 249% return for 1999, ridiculed anyone who doubted that the internet was a perpetual money making machine: ¡§If you¡¦re out of this sector, you¡¦re going to underperform. You¡¦re in a horse and buggy, and I¡¦m in a Porsche (personally I loled there). Clearly Mr. Vilar was not rational in saying this, as the backbone of the economy at the time was the brick and mortar companies (companies with tangible assets). So clearly this investor, who ran a multimillion dollar mutual fund, is not rational. To showcase this, if you had invested $10,000 at the end of 1999 you would have about $1,195 left by the end of 2002. Makes you sick doesn¡¦t it? 3. James J. Cramer, a hedge fund manager, proclaimed in 2000 that Internet-related companies ¡§are the only ones worth owning right now.¡¨ These ¡§winners of the new world are the only ones that are going higher consistently in good days and bad.¡¨ Oh man. As with the above examples, he isn¡¦t looking at what these companies are worth. He is looking at the price of the stock. Sorry James, you¡¦re being branded as irrational. By year end 2002, one of the 10 companies in the fund went bankrupt, and a $10,000 investment would have shrunk to about $597.44. That is freaking scary. I¡¦m not sure which new world James was referring to here¡K.oh wait, an irrational world, where people pay for overvalued stocks that won¡¦t make them any money. The majority of investors are obviously not rational and as long as people are guided by their emotions they never will be. Strike one MPT. Swing and a miss. The first assumption that investors are rational does not stand up for modern portfolio theory to work.
To succeed in trading you need a mechanical (i.e. not subject to human interpretation or opinion) system with positive expectancy tested over several decades and the ability to stick with it. Sticking to your system is crucial and demands rational behaviour. IMO the main reason why investors are irrational is because they pay too much attention to what others are doing. The real poison here is the media that relishes telling you how other people made fortunes with internet startups, tech stocks, gold futures or whatever. These get rich quick stories are either short lived bubbles or statistical outliers. BUT - how are you going to feel when your rational system is going through a gut wrenching 16 month drawdown whilst your friends are quintupling their money by taking bets on this or that? You need to be an emotionless robot and stick to what you KNOW works in the long run. How many robots are reading this?
*The invisible hand is rational superior being you speak of. Agency execution is the closest "entity" that is similar to the invisible hand. Think about it... how many brokers actually act as market makers and how many pass the risk onto an outside firm? you make a trade.. broker finds a dealer too offset your trade or their entire client order book... your brokers broker might do the same with a darkpool or a prime...repeat... gets to the top of the pyramid and the market moves in everyone's favor besides the person who made the trade.