Contributing Writer: Alexandra Dogaru | May, 2022
Every investor’s goal is to beat the market at the lowest possible cost, measured by risk.
However, not every market participant can achieve such a performance. Because of the way financial markets are designed, for every win there is a corresponding loss. With the development of the Modern Portfolio Theory, most analysts’ perceptions of risk and return have changed. The secret? Diversification. Even though research in finance has proven that diversification has its advantages, some wealthy and successful investors, such as Warren Buffett, argue against it.
To begin with, those in favor of the Modern Portfolio Theory, which states that for every reward, there is a corresponding risk, claim that diversifying one’s investments across different asset classes or securities can help achieve a stable return. Spreading investment risk is based on simple statistics such as standard deviation, and correlation coefficients1. In other words, for investors to secure their portfolio’s return against risk, they should employ statistical models that minimize the level of risk for each additional percentage point increase in return.
On the other hand, there is plenty of evidence that rejecting the Modern Portfolio Theory can bring outstanding results, and the most remarkable example is Warren Buffett. As Frazinni et al.2 point out, Buffett’s success has mainly been due to his ability to construct a theory of investing that focuses on navigating high risk, instead of avoiding most of it. This approach contradicts the Modern Portfolio Theory, more specifically its claim that investors should invest in multiple asset classes to avoid the risk of owning only a few risky securities. One common statistic used to calculate the return per level of risk is the Sharpe ratio. To find the Sharpe ratio, an investor takes the portfolio’s return, subtracts the risk-free rate, and then divides this difference by the standard deviation of the portfolio’s return. The higher this ratio,
the better a portfolio or an index fund is managed. Frazinni et al.3 also show that Buffett’s Sharpe ratio, which is consistently above the market’s, does not compare to what most professionals demand. In other words, it seems that Buffett can earn significant returns per risk, but since his Sharpe ratio is below standards, it implies that there must be an additional factor that contributes to his long-lasting success. Buffett has an investing advantage compared to his competition, the investment funds. For example, Ellis4 points out that most investment funds tend to underperform relative to their benchmarks. So, it seems that there must be a secret in investment theory that differentiates Warren Buffett from other investors. One suggestion is that most fund managers tend to be active investors, meaning that they aspire to beat the market by constantly buying and selling securities. As Ellis5 states, one major drawback of excessive buying and selling of securities relates to the costs associated with numerous trades. In other words, it seems that active trading is not the key to success, because after all, nothing is free in the investment world, not even making a transaction.
To provide additional evidence against the Modern Portfolio theory, here are some of Warren Buffett’s thoughts on the Modern Portfolio Theory and the financial theory that is highly acclaimed in schools. In one interview, Buffet claimed that the current theory of investments – mainly the Modern Portfolio Theory – is very misleading6. He states that this is not the way investing should be taught. He then continues to explain that it is a mistake to associate a company’s high rate of return with a high degree of risk7. Based on these insights from “The Greatest Investor of All Time,” it is evident that rejecting the Modern Portfolio Theory can bring fortune to wise investors.
Based on these two opposing views, it seems that the investment theory that is taught in most business schools can be deceptive. I agree, however, that it can help aspiring investors get a better understanding of how capital markets work, but most students tend to overlook this information. What they want to understand is how to build wealth and not make foolish mistakes with their investments. In addition, it can be hard to believe that the Modern Portfolio Theory can make you a billionaire, while Warren Buffet keeps claiming that he does not believe in it.
After all, Buffett has been named the best investor of all time! He keeps consistently making impressive returns on his investments. Based on this, I think that professors need to change the information they teach in finance and investment classes. Maybe there needs to be less focus on the relationship between risk and returns. Instead, aspiring professionals should learn to focus their attention on how a business works and why it generates certain returns.
In conclusion, it seems that the Modern Portfolio Theory, especially the idea of diversification, can be misleading. If we acknowledge that its scope is to help minimize the risk that arises in portfolio construction, then the theory provides valuable insight. If, however, we think about achieving extraordinary returns on our investments, then the theory fails to provide us with an answer. After all, everyone hopes to beat the market and to become wealthy. In my opinion, to achieve those goals and to become financially independent, investors should not base their judgment solely on the Modern Portfolio Theory.
REFERENCE
1 Rasiah D. Post-Modern Portfolio Theory Supports Diversification in an Investment Portfolio to Measure Investment’s Performance. Journal of Finance and Investment Analysis. 2012;1(1). Retrieved from: https://ezproxy.library.wisc.edu/login?url=https://www.proquest.com/scholarly- journals/post-modern-portfolio-theory-supports/docview/2573397251/se-2.
2 Frazzini, A., Kabiller, D., C.F.A., & Pedersen, L. H. (2018). Buffett’s Alpha. Financial Analysts Journal, 74(4), 35-55. Retrieved from: https://ezproxy.library.wisc.edu/login?url=https://www.proquest.com/scholarly-journals/buffetts- alpha/docview/2139472034/se-2
3 Frazzini, A., Kabiller, D., C.F.A., & Pedersen, L. H. (2018). Buffett’s Alpha. Financial Analysts Journal, 74(4), 35-55. Retrieved from: https://ezproxy.library.wisc.edu/login?url=https://www.proquest.com/scholarly-journals/buffetts- alpha/docview/2139472034/se-2
4 Ellis, C. D., C.F.A. (2012). Murder on the Orient Express: The Mystery of Underperformance. Financial Analysts Journal, 68(4), 13-19. Retrieved from: https://ezproxy.library.wisc.edu/login?url=https://www.proquest.com/scholarly-journals/murder- on-orient-express-mystery-underperformance/docview/1033569434/se-2?accountid=465
5 Ellis, C. D., C.F.A. (2012). Murder on the Orient Express: The Mystery of Underperformance. Financial Analysts Journal, 68(4), 13-19. Retrieved from: https://ezproxy.library.wisc.edu/login?url=https://www.proquest.com/scholarly-journals/murder- on-orient-express-mystery-underperformance/docview/1033569434/se-2?accountid=465
6 Niebuhr, K. (2017). Warren Buffett and Charlie Munger vs Modern Portfolio Theory.
Karlbooklover.com. Retrieved from: https://www.karlbooklover.com/
7 Niebuhr, K. (2017). Warren Buffett and Charlie Munger vs Modern Portfolio Theory.
Karlbooklover.com. Retrieved from: https://www.karlbooklover.com/
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