The two key tenets of modern portfolio theory, taught at every university around the world, are that investors hold well-diversified portfolios and that in this setting the only risk that matters is beta risk (volatility-based risk).
Value investors reject both of these tenets. They do not believe that astute investors must hold well-diversified portfolios and they reject the notion that beta is a measure of risk.
First, is there a need for a well-diversified portfolio? Academics regard diversification as a substitute for due diligence. They believe that stock-by-stock analysis is a wasted effort and that diversification will save us all. Of course, as we know from the 2008-09 experience, diversification does not work when we most need it. But even if we accept that diversification reduces risk, its downside is that it also dilutes returns and limits an investment’s upside. In fact, according to economic theory, an extremely diversified portfolio will earn the risk-free rate in the long run – so why then not invest directly in government bonds and cut to the chase? According to Third Avenue Management founder Martin Whitman, “… [I]n a very important sense, recommending diversification is bad advice.” And Warren Buffett once said “diversification is protection against ignorance. It makes little sense if you know what you are doing.” This is something that John Maynard Keynes echoed in years past.
But beyond this, diversification would work if we knew all possible risks – both the risks we know we do not know and the risks we do not know we do not know. But we do not. Diversification does not protect you against the risks you do not know you do not know – also known as “fat tails.”
The first academic to discuss this was Keynes, but this view of risk did not prevail as it was difficult to quantify and capture in mathematical models. What prevailed was the view that risk is like roulette. That is, we know all the odds even though we do not know what will eventually arise. This coin-tossing view of the world is behind all models of risk management that are available and taught at universities, such as Black and Scholes, value at risk, market efficiency and so on. Unfortunately, risk in the markets is not like roulette. In roulette the odds are fixed, and what we observe around us does not affect the odds.
Our world is more like a poker game, where whatever we observe around us affects the odds. Also, what many math-oriented academics miss is that finance is not a natural phenomenon, like physics, it is man-made by humans who, in their effort to manage risk, affect risk itself. And human behaviour is difficult, if not impossible, to model. For example, Andrew Lo from MIT recently wrote an article titled Warning: Physics Envy May Be Hazardous To Your Wealth, in which he explains how “physics envy” has created a false sense of accuracy in finance.
Value investors want to reduce risk without limiting the upside. How do value investors handle risk? They select securities whose business they understand with history of stable cash flows and they employ position limits, among other risk-mitigating strategies. But more importantly, value investors employ the concept of margin of safety. That is, they only buy if a stock is well below the intrinsic (fundamental) value. But let me be clear, they do not totally reject diversification. If they did, they would hold only one stock. They tend to hold very concentrated portfolios of between 15-30 stocks. They believe that some diversification along with the margin of safety go a long way in dealing with the risks discussed above.
Second, is beta a risk measure? Value investors reject the notion that beta is a measure of risk. Risk for value investors is not volatility. Volatility is good; risk is the possibility of permanent loss of capital. As Oaktree’s Howard Marks explains, we can ride out volatility, but we will not be able to get a chance to recover from permanent loss of capital. We have permanent loss of capital, for example, when investing in an overleveraged company that will go bankrupt in a recession or when investing on margin and forced to sell even though this may be undesirable. In these cases, an investor will have permanent loss of capital. Even the father of beta, Eugene Fama from the University of Chicago, in a recent paper he wrote titled “A look back at modern finance: accomplishments and limitations,” he dismisses beta as “garbage.”
Will this change the views of risk at most universities? Of course not. Academics are too invested in the status quo to have a few value investors or even a few aging academics argue against modern portfolio theory.
So next time you hear that we must diversify and that beta is a measure of risk, ask for an explanation of why those concepts and what is taught in finance courses at universities around the globe have been mocked by billionaire investors such as Warren Buffett, Charlie Munger and Seth Klarman.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.Report Typo/Error
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