Diversification, asset allocation and the need to take higher risk to achieve higher returns are concepts on which the investment advice-giving and money-management industries have capitalized on for years. The foundation of these concepts is Modern Portfolio Theory (MPT). But is it the proper approach to rely on for financial well-being?
The theory relies on a number of faulty concepts to which, unfortunately, most academics still cling. First, that markets are efficient. Second, that all investors buy well-diversified portfolios and the only risk that matters is beta (that is, the stock’s relationship with the market portfolio). Third, that all investors are rational, and lastly that all participants are honest, honourable and noble.
None of the above is true.
Markets are not efficient in the short run. Value is not the same as price at every point in time. Nobel Prize winner Robert Shiller referred to market efficiency as “one of the most remarkable errors in the history of economic thought.” And there is a lot of academic evidence in favour of market inefficiency; the most remarkable is the Volatility Effect, showing that lower-risk stocks have had higher historical returns than higher-risk stocks.
Because of their belief in market efficiency, academics have paid little attention to value investing and stock picking. Academics regard due diligence and stock-by-stock analysis as a wasted effort, arguing that one does not need to spend time understanding a company and its business, as diversification will save us all. To be fair, diversification could work, but only if we knew total risk, which we do not. There are two types of risk: the risk we know we do not know and the risk we do not know that we do not know. John Maynard Keynes was the first economist to discuss these concepts, but his views were not easily modelled and quantified and thus did not prevail. What prevailed were the views of mathematician Thomas Bayes, who equated market risk to a game of roulette. Yet in roulette, we know what we do not know, as the odds are fixed/known and nothing we do can change them. Market risk is more like a game of poker where the odds change by what we observe around us.
Most successful investors do not diversify, they concentrate because they have a bottom-up approach and understand a business well before investing. Keynes once said that if you know what you are doing, diversification is undesirable, something that Warren Buffett echoes. Moreover, if one has a concentrated portfolio and a long-term horizon, volatility is not risk and, because beta is based on volatility, beta is irrelevant.
If we dive further into the MPT’s assumption that people are rational, we are met with plenty of evidence that the opposite is true. People are known to herd, to naively extrapolate past performance, to be overoptimistic and overconfident, to be impatient and to panic and get exuberant at the wrong times. In a ground-breaking study, researchers at BlackRock showed that while the average U.S. equity fund returned about 8 per cent over the past 30-plus years, the actual investors in these funds made only 2 per cent. Why? Because they tried to time the market, buy high and sell low responding to the human trait of panic when markets fell and exuberance when the markets rose.
The issue with the MPT’s assumption that all participants are honest, honourable and noble really comes down to conflicts. Market participants have conflicts that prevent them from acting in a forthright way when dealing with others and stock prices tend to diverge from value because of this reason. The well-known January and the “sell in May and go away” effects are two stock price patterns driven by conflicts that portfolio managers have.
Factor investing is partly an outcome of this faulty view of the world. It’s a variation of index investing. Factor investing with value tilts is not the same as value investing.
Value investing involves three steps; the first entails screening stocks by a number of valuation metrics such as the price/earnings (P/E) or price/book value (P/B), among others, in order to determine possibly undervalued stocks; the second step entails valuing all the possibly undervalued stocks that pass through the first step to determine their intrinsic value from a bottom-up approach; and the final step entails making a decision using the concept of margin of safety. Only stocks that meet a predetermined margin of safety are considered worth investing in.
Understanding how value investing works, it becomes obvious that factor investing only relates to the first step of the value investing process and is quite mechanical without any requirement to study the business carefully from a bottom-up approach.
Here is my advice for successful investing. You need: first, reasonable intelligence; second, an appropriate process that involves an analytical approach in making investment decisions, a good valuation model, thorough understanding of a business, great degree of homework, independence and a concentrated portfolio; and finally, and most important, one needs to have the right character that involves patience, discipline, tendency to go against the herd, a long-term horizon and a keen understanding of human nature and institutional biases.
None of this has anything to do with MPT and factor investing. It has to do with the system developed by Ben Graham that identifies investments with a low probability of permanent loss of capital, and limited downside without sacrificing the upside, a process called value investing.
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
George Athanassakos