When Warren Buffett and Nassim Nicholas Taleb declare something related to investments a pile of nonsense, you best listen up.
In a brilliant column in The Financial Times, Taleb writes that the modern portfolio theory has the "the empirical and scientific validity of astrology (without the aesthetics), yet the lessons are ignored in what is taught to 150,000 business school students worldwide."
He also takes the folks awarding the Nobel Prize in Economics to task for legitimizing these nonsense theories with that prestigious award.
What does all this mean for investors? Most financial advisors/planners/what used to be called brokers use MPT as the basis for constructing your portfolio -- and they charge you big fees for doing this.
If you accept Taleb's argument that it's all a bunch of crap, you've taken the first step toward doing the smartest thing you can do for your financial future: ditch your broker and buy low-cost index mutual funds.
Taleb rips modern portfolio theory a new one
Posted Oct 23rd 2007 5:13PM by Zac Bissonnette
Filed under: Newspapers, Personal finance
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Reader Comments (Page 1 of 1)
10-24-2007 @ 12:12AM
beanspants said...
I'm guessing by your comment
"the smartest thing you can do for your financial future: ditch your broker and buy low-cost index mutual funds"
that you have no idea what modern portfolio theory actually entails, unless you mean to buy a low-cost index mutual fund (single), because if you buy more than 1, then you obviously believe in modern portfolio theory. It also means that you don't believe in owning a mutual fund and a money market fund or bond fund, because that too would mean that you believe in modern portfolio theory.
Now, I haven't read the article, because I don't want to register with Financial Times, but if you made such an basic mistake in analyzing the article, then he probably didn't make much of a case and made moronic limitations on what "modern portfolio theory" that is taught in MBA schools across the country actually means.
To recap so you'll understand my point: Portfolio theory aims for hitting the sweet spot on the CAL for a number of assets. The assets could be a group of mutual funds, individual stocks, money markets, savings accounts, bonds, online poker, hookers, thievery, etc.
Now, as a simple example, the way you decide how much to put in your mutual fund and keep in your savings account without portfolio theory is to simply eyeball your accounts and take a guess, say 90% mutual & 10% savings account.
With portfolio theory, instead of just eyeballing, you check the variance and average return to take an educated guess at the best ratio. Now it's 92% mutual and 8% savings.
Now, any number of studies have suggested that humans are no good at understanding risk, so maybe your eyeball at 90% mutual is right, but in most cases, MPT will get you a better ratio with higher returns and less risk. Also, you may feel that whatever cost is associated with rebalancing your portfolio to find the better ratio between 90% and 92% is not worth the cost, but over a longish period of time you'd be wrong.
Now, if you fully don't believe in MPT, then you don't believe in the powers of diversification, so you'll want to only own one asset, whichever of savings account, mutual fund, individual stock, bond, single hooker, online poker, thievery, etc, that you think will bring the most return over your time period.
10-23-2007 @ 11:41PM
beanspants said...
Oh yeah, one more thing:
It seems as if the author (and WikiPedia) are trying to set up some sort of dichotomy between 'value investing' championed by Buffett versus MPT. None exists. They are decidedly complementary, not at all at odds.
Berkshire Hathaway is most assuredly a MPT weighted company, as again, it is highly diversified and more, the ratios of revenue/captial investment/expeditures between the divisions are not equal, nor were they decided by WB tossing out some guesses on which unit to finance.