The fantasy world of modern portfolio theory

The calendar year of 2011 will soon come to a close, and active managers will be watching to see how the performance for the year will turn out.

Many who hire active managers will also be watching closely, and will be judging whether or not they should continue to keep their investments with this or that manager based upon the outcome when the market closes on Friday, December 30.

Others, who disavow active management, will be watching in order to see how many managers failed to "beat the market" (or beat their benchmark) so that they can declare that "active management doesn't work" and that everyone should "just index."

While we believe that keeping score is important in investment management, we don't agree that the emphasis placed on a calendar year is the best way to determine whether any particular manager is doing a good job, nor is it the best way to determine the broader question of whether active management is better than (so-called) passive management or vice versa.

For starters, we have argued that investors often have far too short-term of an attention span when it comes to committing capital to businesses, much the way that the Ents in J.R.R. Tolkien's Lord of the Rings criticize hobbits for being too hasty. Would anyone select a money manager based upon whether or not his overall portfolio of investments went up or down on a single day? That would be ridiculous. How about based upon whether or not his portfolio outperformed "the market" or some other benchmark during a single day?

If you had a friend who told you that he moved his life's savings from one manager to another based upon which one did the best the day before, you might (like Treebeard) advise him, "Don't be so hasty."

The same could be said for jumping to conclusions about whether active management is better than passive management. It would be ridiculous for financial commentators to publish reports declaring "Several prominent active managers underperformed the market yesterday, leading to the conclusion that active management may not be the best way to invest."

We would argue that, while better than a single day, a single calendar year is not the most useful time period to select, but that investors should instead focus on longer periods, and should consider start and end points that are less arbitrary than the annual calendar but which correspond instead to major economic events (such as from one recession to another).

More importantly, the broader question of active versus passive management should not be decided based upon arbitrary and short periods of time. If active managers beat the market or their benchmark in one year or even in two or three consecutive years, some critics will always be waiting to pounce on them in a year that they do not, in order to declare that the mathematics are irrefutable and that nobody can beat the market in the long run. More precisely, these critics will often argue that anyone who does beat the market for a few years does so by taking "excessive risk" which could have been avoided by owning more securities. Since no one can really beat the market without undue risk, the passive advocates argue, then it is best to just buy the market -- that way, you will get the best possible return for the amount of risk that you take.

The mistaken idea that passive management is the best way to invest is one outgrowth of a much larger academic theory called "modern portfolio theory" which has slowly expanded its influence in the investment world, beginning in 1974. We have written about its problems numerous times in the past, such as in this previous post. The distinctive concept at the core of this theory is the idea that risk can be captured in mathematical formulas, and that because it asserts that risk is mathematically linked to potential returns, its advocates believe that mathematical analysis and diversification can point investors to the optimal level of risk and return for their investment profile (the so-called "efficient frontier" is an example of this concept).

This seemingly harmless idea manifests itself in many different ways in the investment industry, one of them being the idea that owning indexes with hundreds or even thousands of individual securities provides better "risk-adjusted return" than owning a smaller number of carefully-selected securities. If you think about it carefully, you will be able to see that this idea (which is at the heart of the "just index" or "passive investing" argument) was also behind the construction of the various structured investments and synthetic vehicles full of sub-prime mortgages which banks and other financial institutions bought under the illusion that enough diversification and the right mathematical models would make the analysis of the individual loans unnecessary. This fantasy led directly to the disastrous financial meltdown of 2008 and 2009.

In this regard, modern portfolio theory resembles the kung fu seen in certain martial arts movies like the one above -- it's a nice fantasy, but it is completely divorced from the real world. Thinking that its mystical precepts will keep you from ever getting cut in a real knife-fight could have disastrous consequences.

It is our conviction that in the real world of investing, there will be times when good investments are out of favor and therefore perform "worse than the market," whether for a day, a month, or even a year. The idea that owning a small number of good investments (even if they sometimes go in and out of favor) is "risky" but that owning a huge number of unexamined investments mitigates risk is actually a dangerous fantasy, and one that unfortunately is pumped out to viewers and readers daily by the financial media in video, magazines, and books. Investors who are tempted to buy into this fantasy should be cautioned that modern portfolio theory's vision of investing is as divorced from reality as mystical movie kung fu is from real fighting.

For investors who want to practice real investing, we would advise that finding quality businesses is not as difficult as they might think -- we have discussed criteria for doing this and provided several examples in previous posts (a list of some of them can be found here). They should then plan on owning those companies through the inevitable ups and downs of the market for long periods of years (this does not mean holding them forever -- we discuss sell discipline in other posts such as this one -- but rather owning them until the business signals that it is no longer the kind of business you want to own, instead of relying on the market signals that so many investors and pundits focus on).

Take a look at the kind of returns an investor could have experienced if he had purchased shares in Wal-Mart in 1982 and owned them through 1992*. Look closely at the chart and you will see that there were plenty of ups-and-downs along the way, including some sudden and rather severe drops: what would that investor have missed if he had been listening to what all the pundits were saying or if he had the mistaken idea that owning a tiny piece of a truly great company could be done without ever taking some hits and receiving some bruises?

Understanding this perspective is the first step towards building a strategy that is based on principles that investors should be focused on, instead of building one that is based on the fantasy of modern portfolio theory and its quest for "risk-adjusted return." It will also enable investors to see most of what appears in the financial media for what it really is -- entertainment that might offer an enjoyable escape into a fantasy world, but which should not be confused with reality, and actually isn't even as fun to watch as a good old-fashioned kung fu flick.

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Wal-Mart Stores, Inc. (WMT).