Wednesday, April 24, 2013

Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited

"...Berkshire's whole record has been achieved without paying one ounce of attention to the efficient market theory in its hard form. And not one ounce of attention to the descendants of that idea, which came out of academic economics and went into corporate finance and morphed into such obscenities as the capital asset pricing model, which we also paid no attention to." - Charlie Munger at UC Santa Barbara back in 2003

With this year's Berkshire Hathaway (BRKa) annual shareholder meeting coming up soon, I decided to take a little time to browse some of the notes taken at past meetings.

As always, lots of useful stuff that's well worth reading (and, I guess in my case, re-reading). Well, one exchange that caught my attention comes from the 2006 meeting. At that meeting, Warren Buffett and Charlie Munger covered the subject of efficient market hypothesis (EMH) and modern portfolio theory (MPT) a bit.

Here's what they had to say about EMH and MPT at the 2006 meeting according the notes taken by The Motley Fool:*

Warren Buffett: The teaching of finance has improved over the past 20 years, but from a very low base. The flat-Earth orthodoxy of 20 years ago, of modern portfolio theory and the efficient market hypothesis, is breaking down. [The universities] of Kansas, Missouri, Florida, Columbia, and Stanford, among others, have good programs. Twenty-five years ago, you couldn't get a job or advance if you didn't go along with the EMH [Efficient Market Hypothesis] and MPT [Modern Portfolio Theory] orthodoxy.

Nowadays, students all think they'll get rich doing what Charlie and I do. The amount of brainpower going into money management is somewhat distressing, but it's a great time to be 20 or 25 years old and be getting out of school. A lot of students who come to visit say that they want to go into private equity or hedge funds. I'm not sure what the economy is going to do for basics like food and clothes.

Charlie Munger: Half of the business school graduates at the elite Eastern schools say that they want to go into private equity or hedge funds. Their goal seems to be to keep up with their cohorts at Goldman Sachs (NYSE: GS). This can't possibly end well.

At that same meeting they later had the following to say:

Charlie Munger: Finding a single investment that will return 20% per year for 40 years tends to happen only in dreamland. In the real world, you uncover an opportunity, and then you compare other opportunities with that. And you only invest in the most attractive opportunities. That's your opportunity cost. That's what you learn in freshman economics. The game hasn't changed at all. That's why Modern Portfolio Theory is so asinine.

Warren Buffett: It really is, folks.

Charlie Munger: If Warren were starting today, he'd put together a concentrated portfolio. Your one or two best ideas are way better than the rest. So when you act, you're thinking about how the alternatives compare with your best idea. But you don't want to own your 10th-best idea when you can use that cash to invest in your best idea.

Warren Buffett also brought the same subject up in the 2006 letter, using the record of Walter Schloss as an example:**

"I first publicly discussed Walter's remarkable record in 1984. At that time 'efficient market theory' (EMT) was the centerpiece of investment instruction at most major business schools. This theory, as then most commonly taught, held that the price of any stock at any moment is not demonstrably mispriced, which means that no investor can be expected to overperform the stock market averages using only publicly-available information (though some will do so by luck). When I talked about Walter 23 years ago, his record forcefully contradicted this dogma.

And what did members of the academic community do when they were exposed to this new and important evidence? Unfortunately, they reacted in all-too-human fashion: Rather than opening their minds, they closed their eyes. To my knowledge no business school teaching EMT made any attempt to study Walter's performance and what it meant for the school's cherished theory.

Instead, the faculties of the schools went merrily on their way presenting EMT as having the certainty of scripture. Typically, a finance instructor who had the nerve to question EMT had about as much chance of major promotion as Galileo had of being named Pope.

Tens of thousands of students were therefore sent out into life believing that on every day the price of every stock was 'right' (or, more accurately, not demonstrably wrong) and that attempts to evaluate businesses – that is, stocks – were useless. Walter meanwhile went on overperforming, his job made easier by the misguided instructions that had been given to those young minds. After all, if you are in the shipping business, it's helpful to have all of your potential competitors be taught that the earth is flat."

At least there seems to be some progress, however painfully slow it has unfortunately been, in academia and elsewhere on this front.

For quite a while it seemed like that would never happen.

These days, fewer buy into this stuff but there is still, remarkably, no shortage of adherents. I think Marty Whitman has it about right when he said the following about modern portfolio theory in this Barron's interview:

" far as value investing, control investing, distress investing and credit analysis is concerned, that stuff is absolute garbage."

Here's what Buffett said more recently about efficient markets in the 2010 Berkshire Hathaway shareholder letter:

"John Kenneth Galbraith once slyly observed that economists were most economical with ideas: They made the ones learned in graduate school last a lifetime. University finance departments often behave similarly. Witness the tenacity with which almost all clung to the theory of efficient markets throughout the 1970s and 1980s, dismissively calling powerful facts that refuted it 'anomalies.' (I always love explanations of that kind: The Flat Earth Society probably views a ship's circling of the globe as an annoying, but inconsequential, anomaly.)"

To me, whether the criticism happens to be delivered politely, sarcastically or-- in the case of Charlie Munger or Marty Whitman -- maybe a bit more harshly, it seems just as valid. These ideas aren't necessarily just useless, they're actually capable of doing real economic damage over time.

With this example in mind, I'll never again be surprised by how long certain extremely flawed ideas persist when, on merit, they should not.


Long position in BRKb established at much lower than recent market prices

Related posts:
-Buffett on Risk and Reward
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Grantham on "The Greatest-Ever Failure of Economic Theory"
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind

* Since these are notes it's not possible to know if the quotes are exact, of course.
** From the 2006 letter: "Following a strategy that involved no real risk – defined as permanent loss of capital – Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500."

Buffett then added...

"There is simply no possibility that what Walter achieved over 47 years was due to chance."
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