Leithner Letter No. 53
26 May, 2004

Needless to say, Graham and Dodd investors do not discuss beta, the Capital Asset Pricing Model or covariance of returns ... these are not subjects of any interest to them. In fact, most of them would have trouble defining those terms. [They] simply focus on two variables: price and value.

Warren E. Buffett
The Superinvestors of Graham-and-Doddsville (1984)

The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by a more conventional investor. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as “the possibility of loss or injury.”

Warren E. Buffett
Berkshire Hathaway Annual Report (1993)

Naturally, the disservice done students and gullible investment professionals who have swallowed [efficient markets theory] has been an extraordinary service to us and other followers of Graham. In any sort of contest – financial, mental or physical – it’s an enormous advantage to have opponents who have been taught it’s useless to even try. From a selfish standpoint, we should probably endow chairs to ensure the perpetual teaching of EMT.

Warren E. Buffett
Outstanding Investor Digest (8 August 1996)

A Rerun of That 70s Show?

An unprovoked war fought on false pretences, largely by the American military and against an increasingly tenacious resistance in an impoverished and distant land; a tsunami of government expenditure that rankles a minuscule and reprobate band of constitutionalists; persistently and unnaturally low rates of interest and an ostensible revival of the pace of economic activity; a rebound of stock and bond prices after a nasty fall; and a growing trade deficit, steadily falling $US and erratically rising price of gold. These phrases describe contemporary America and the policies of George W. Bush. But they also describe the America of 1970-72 and the policies of Richard M. Nixon. If, as Mark Twain counselled, history does not repeat but rhymes, then it is worth investors’ while to ponder whether Mr Bush’s policies will produce results similar to Mr Nixon’s.

The analogy, of course, is perilous: to say that two periods of time share characteristics a, b and c is hardly to reason validly to the conclusion that they will also share features x, y and z. Iraq, for example, and as several Australian commentators have indignantly and stridently insisted in recent weeks, is not Vietnam. Tellingly, however, thus far they have said precious little about the closer analogy of contemporary Iraq to the French débâcle in Algeria in the 1950s and 1960s, and to Israel’s imbroglio in Lebanon in the 1980s and 1990s (see, however, The Australian Financial Review 16 April). And virtually nothing has been uttered in this country about the parallels with Britain’s disastrous intrusion in Mesopotamia during and after the First World War. On that fiasco see Thomas Lawrence, also known as Lawrence of Arabia, and A Report on Mesopotamia.

Perilous or not, the economic comparison is tempting – and ominous. In 1970, a year of recession (according to the National Bureau of Economic Research, the semi-official arbiter of such things), Mr Nixon, with an accommodative central bank blowing briskly at his back, opened a floodgate of expenditure, artificially stimulated economic activity and revived animal spirits in financial markets. In 1972, allegedly a year of strong recovery, Nixon hit the campaign trail and, promising even better times to come, won re-election by an extraordinary landslide. His second term was correspondingly historic. But it was not, to put it mildly, glorious: in 1973-75 the economy, stock and bond markets, South Vietnam – and the Nixon administration itself – collapsed.

The proximate causes of the disintegration (Keynesian policies that generated stagflation and a Machiavellian mindset that spawned felonies at home, war crimes abroad and denials and cover-ups everywhere) had been implemented years before. Indeed, whilst Nixon assiduously fanned its flames, in both economic and military terms the interventionist kindling was lit during the Kennedy and Johnson presidencies. Barron’s (“That 70’s Show” 17 November 2003) noted that “wilfully or not, the Bush administration seems to have ignored the two biggest economic lessons of the Nixon era: artificial stimulation of the economy, via tax or interest-rate cuts, almost always backfires; and running deficits can be dangerous, particularly when foreigners finance them” (see also “Guns and Butter Seldom Mix” The Australian Financial Review 13 April). Wayne Nordberg, chairman of Hollow Brook Associates of Gladstone, New Jersey and cited in the Barron’s article, summarised the possible consequences of today’s policies. “We’ve revived the stock market, but at a tremendous cost to our national balance sheet. The real bear market is ahead of us, not behind us.”

The worst financial and economic disaster of the twentieth century was the Crash of 1929 and the Great Depression that followed (but was not caused by) it. The second-worst was the recession and bear market of the 1970s. As in 1929 and into the 1930s, the 1970s bear market and recession was felt in all Anglo-American countries. The recession generally began in 1973, and the bear market, depending upon the country and one’s definition, lasted until 1982. But unlike the Crash, the funk of the 1970s did not begin on a single horrific day. Nor were its effects as devastating. And in Australia, attention was distracted from economic matters towards an unprecedented political drama. (The upper house of Parliament refused supply to the lower house; and the Queen’s representative, the Governor-General, sacked a Prime Minister with a clear and workable majority in the lower house.) Perhaps for those reasons, and despite their greater temporal proximity, the recession and bear market of the 1970s do not evoke the same uniformly dreadful memories as the 1930s.

Yet in one critical respect the 1970s – and their possible lessons for the present – are as significant as the 1930s. If the Great Depression witnessed the rapid rise to orthodoxy of a destructive set of economic ideas (Keynesian economics), then the 1970s saw the accession to convention of a harmful set of investment ideas (modern portfolio theory). To escape the dead hand of the past – in Mark Twain’s words, to ensure that the future does not rhyme with either the 1930s or 1970s – it is necessary to purge these two vexatious notions. The recession and bear market of the 1970s was an excruciatingly extended affair. Week after week and month after month (and, indeed, year after year) the prices of stocks and bonds fell. One of Benjamin Graham’s employees and Warren Buffett’s colleagues at Graham-Newman Corp. during the early 1950s, William Ruane, managed funds through the 1970s. He recalled “we had the blurred vision to start the Sequoia Fund in mid-1970 and suffered the Chinese water torture of underperforming the S&P four straight years. We hid under the desk, didn’t answer the phones and wondered if the storm would ever clear.”

Moods were bleak because things that from the point of view of a Keynesian economist were impossible (and thus inexplicable) occurred at the same time. There was not just a recession and rising unemployment but also interest rates and a Consumer Price Index soaring into double digits. In partial recognition of the shock these events delivered to the mainstream – and of the ability of the Austrian School to explain them – in 1974 Friedrich Hayek, whose insights had been marginalised, ridiculed or ignored since the 1930s, was awarded the Nobel Prize in Economic Science. (But this recognition was clearly grudging: much to Hayek’s irritation, he shared that year’s prize with the unrepentant socialist Gunnar Myrdal.)

So severe was the financial damage and emotional despair that, for the first time since the 1930s, managers, advisors and influential individual investors began to question their principles and methods. They sought answers but did not ask the best student, most energetic colleague and successful follower of the acknowledged founder of security analysis. In the 1970s Warren Buffett could point to an outstanding twenty-year track record of investment management, based upon Graham’s insights and methods, and he took every possible opportunity to credit Graham for his success.

But Buffett had closed his partnership in 1969 and was concentrating upon the migration of capital from poor businesses into more favourable businesses. Buffett was revered by the many who knew him; alas, at that stage nobody could conceive how he would remake Berkshire Hathaway and so he was not yet universally known. Nor did investment advisors and managers turn to Graham. He was universally recognised and his articles “Renaissance of Value: Rare Investment Opportunities Are Emerging” (Barron’s 23 September 1974) and “The Future of Common Stocks” (Financial Analysts Journal September-October 1974) cogently restated the case for sober and businesslike investing during trying times. Graham reaffirmed principles and presciently pointed the way ahead. But in the final years of his life (he died in 1977) his involvement and interest in financial matters was relatively slight. Instead, most advisors and institutional investors turned – most of them implicitly and a few with great reluctance – to a small number of academics and a growing body of academic research. Collectively, this research has come to be called modern portfolio theory (MPT). Among its most important strands are the capital assets pricing model (CAPM) and the efficient markets theory (EMT).

That 70s Financial Orthodoxy

MPT is premised upon several sets of notions: all market participants have the same information and expectations and react identically to new information; price and value are synonyms; the prices of securities, which adjust so quickly to new information that they are unpredictable and thus render “excess” returns impossible and the analysis of businesses and securities superfluous, nonetheless bear a common relationship to an underlying base factor; the more volatile a security’s price, the greater its risk; and risk and return are inextricably linked such that the greater the desired return, the greater the risk one must accept (for a readable background and introduction, see Burton G. Malkiel, A Random Walk Down Wall Street, W.W. Norton, 1973, 2004, ISBN: 0393325350).

The base factor for the prices of stocks – and hence the single greatest influence upon their fluctuations – is the general level of prices (represented by a price index such as the All Ordinaries or S&P 500). Accordingly, if a given stock’s price is more (less) volatile than that of the market as a whole, then it is a more (less) “risky” stock. Further, a particular security carries two sets of risks. One (“systemic risk”) inheres in any security whose price is subject to market fluctuations; and the second (“unsystemic risk”) is specific to the stock. Recession, war, technological developments in the industry, scandal within the boardroom and unexpectedly bad (or good) management can exacerbate the price volatility of a stock and hence its unsystemic risk. Whether for a single security or a portfolio of securities, a two-dimensional graph depicts the relationship between risk and expected return. Expected return is measured on one axis and risk on the other, and the “efficient frontier” is simply a line or curve drawn from the graph’s bottom-left to its top-right. Each point on the line represents an intersection between a potential return and its corresponding level of risk.

The most efficient portfolio is the one that generates the highest return that is consistent with a given level of risk; and an inefficient portfolio exposes its owner to a level of risk that does not offer a commensurate rate of return. An investor’s goal is to select an efficient portfolio of securities that corresponds to his desired or tolerated level of risk. The most efficient portfolio is the market itself. No other portfolio with equal risk can offer a higher expected return; and no other portfolio with an equivalent expected return will be less risky. In practical terms, according to MPT, the most efficient portfolio is an “index portfolio” that is composed of a representative sample of the securities that comprise its “benchmark” index. A portfolio’s risk is not measured in terms of the average price volatility of the securities that comprise it. Rather, it is the extent to which each security’s volatility is correlated with the volatility of the others in the portfolio.

The more prices move in the same direction, the greater the possibility that economic or political or other events will depress them simultaneously. Conversely, a portfolio that comprises risky (if considered individually) securities might actually be conservative if the volatility of their prices is not correlated (i.e., they move in different directions in response to a given stimulus). Either way, diversification is a foundation of modern portfolio theory. An investor informed by MPT first identifies the extent to which he tolerates price volatility; then, given this level of acceptable risk, he constructs an efficiently diversified portfolio. The originally-disparate threads of what has become known as MPT became tightly intertwined during the 1950s and 1960s. At that time most professional and institutional investors ignored these academic developments. But during the early and mid 1970s, in a kind of stampede reminiscent of the sudden elevation in the late 1930s and war years of Keynes’s General Theory to unrivalled conventional wisdom, investors’ indifference to academics and MPT was abruptly replaced by close attention and growing obeisance.

According to Peter Bernstein (Capital Ideas: The Improbable Origins of Modern Wall Street, The Free Press, 1993, ISBN: 0029030129), “the market disaster of 1974 convinced me that there had to be a better way to manage investment portfolios. Even if I could have convinced myself to turn my back on the theoretical structure that the academics were erecting, there was too much of it coming from major universities for me to accept the view of my colleagues that it was ‘a lot of baloney.’” By the 1980s, MPT had become an unquestioned orthodoxy within universities and was embraced by the mainstream in Wall Street. According to John Train (The New Money Masters, Harper & Row, 1989, ISBN: 0060159669), it “has become so accepted in academia that, as Michael C. Jensen of the University of Rochester has said, we are dangerously close to the point where no graduate student would dare send off a paper criticising it.

Nonetheless, many of the best investment practitioners, including Buffett, regard it as absurd.” These developments occurred quickly and without the knowledge of or deliberation by members of the general public. Perhaps for these reasons, the implications of these developments have been less recognised and more profound than might appear at first glance. A major consequence of the Keynesian revolution has been the concentration of vast amounts of other people’s money and power to make decisions in the hands of politicians and élite policymakers (often advised by academics in prestigious universities). Similarly, a major consequence of the MPT revolution has been the concentration of vast resources and authority to allocate them in the hands of a small number of institutional investors (also advised, directly or indirectly, by academics). Neither politicians nor academics, it seems, trust individuals to be the primary arbiters of economic and financial destinies. Nor, apparently, can standards of living depend upon capitalists and entrepreneurs. Instead, the fortunes of hundreds of millions and perhaps billions are owed to a small number of suitably pedigreed people in places like Washington and New York; and the ideas that inform their decisions derive from the best and brightest people in the most prestigious universities. Once they were obscure and safely ignored residents of ivory towers; but today élite academics are much more prominent and powerful high priests of economics and finance.

Orthodoxy, Arrogance and Error

The concentration of vast quantities of other people’s money in the hands of politicians, bureaucrats, funds managers and their academic advisors – anybody, in short, other than the money’s owners – is a distinctly unwelcome development. In the days of our eighteenth, nineteenth and early-twentieth century forebears, individuals were free (subject to conscience and common law) to conduct their financial affairs as they saw fit. For the most part, anybody intelligent (or lucky) enough to accumulate capital also regarded himself to be smart enough to manage it. A few of their decisions were undoubtedly very shrewd, a few appallingly stupid and the remainder passable and adequate. On the whole, however, these many individual decisions formed a natural and stable balance. To evoke a Hayekian image, it was not the rigid balance of an ugly and quickly erected cement building but rather the ecological balance of an ancient hedgerow.

Alas, one basis of a free society, namely the prominence and preponderance of self-employed and independent business owners, has weakened drastically over time. Those who decide for themselves with respect to assets, prices and incomes are far fewer in number today than they were a century ago; and today’s salary earners tamely and unthinkingly accept a degree of direction and coercion that their pioneering and autonomous forebears would rightly have regarded as intolerable infringements upon conscience and liberty. (On 10 April, to cite just one current example, Brisbane’s The Courier-Mail tamely stated “Treasurer Peter Costello’s salary – a shade under $200,000 a year for ensuring the smooth running of the entire economy – is often cited by politicians willing to argue that their pay packets are not excessive.”)

Even worse, given that today’s economic and financial élites are advised more and more by élite academics, decision-makers tend to think ever more alike. And given the quantum increase of the speed at which information is disseminated, these ever fewer and larger units of decision-making are tending to act more and more alike. As a result, the economic boat which used to be manned by countless mice is now steered by a handful of elephants. Because they are herd-conscious elephants, at critical junctures the boat becomes wobbly and unbalanced; and because they are arrogant elephants, their colossal mistakes (whose consequences, to add insult to injury, are borne not by the anointed but by the benighted) are seldom if ever followed by restitution and apology. Whether you’re in business or government, to be an élite decision-maker is virtually never to say you’re sorry for your appalling blunders. To disperse decision-making is to localise and thereby minimise the consequences of the mistakes that regularly and inevitably accompany human action. It is also to reap the benefits of trial and error, cautiously adopting and extending successes and retiring failures. Conversely, to concentrate power is to magnify the consequences (such as denial, corruption and cover-up, tyranny and widespread calamity) that accompany egregious error.

In capital markets in recent years, centralised decision-makers and arrogant academics have often been wrong but never in doubt; and the damage they have wrought has been considerable. (For very readable elaborations of this fundamental point, see three books by Roger Lowenstein: Origins of the Crash: The Great Bubble and Its Undoing, The Penguin Press, 2004, ISBN: 1594200033; When Genius Failed: The Rise and Fall of Long-Term Capital Management, Random House, 2001, ISBN: 0375758259; and Buffett: The Making of an American Capitalist, Random House, 1997, ISBN: 0517194961.) Just as the funk of the 1970s tarnished the reputation of Keynesianism, the Crash of 1987 and the bursting of The Great Bubble have dented the stature of MPT. As Andrei Shleifer and Lawrence Summers put it, “the stock in the efficient market hypothesis – at least as it has traditionally been formulated – crashed along with the rest of the market on 19 October 1987.”

But not everyone (which is curious, given MPT’s assumptions) noticed that its stock had crashed. Richard Brealey and Stewart Myers, for example, authors of Principles of Corporate Finance, conceded in editions published after the 1987 Crash that Black Monday posed “some problems.” They reassured their readers that “in an efficient market you can trust prices” – but neglected to specify which prices, pre- or post-crash, are trustworthy. Prices “impound all available information about the value of each security ... in an efficient market there are no financial illusions.” So don’t you fret: despite 1987 and The Great Bubble, the orthodoxy remains “remarkably well-supported by the facts.”

In response to these rebukes from the real world, economic and finance literatures have retreated from unqualified claims into ever more arcane mathematical obfuscation. It is true that a new generation of academics, embracing insights from psychology and other disciplines, has during the past decade created an emerging field of “behavioural finance” which seems to challenge the assumptions and findings of MPT. Indeed, Burton Malkiel says that he now treads a “middle road” between MPT and the behaviourists. But it is equally true that many funds managers and their advisors (like the politicians, bureaucrats and business journalists that remain wedded to the crude Keynesianism abandoned long ago by academics) continue unabashedly to implement MPT as if nothing were amiss. And the gulf between behavioural finance and orthodoxy is more apparent than real. As Andrei Shleifer laments in Inefficient Markets: An Introduction to Behavioral Finance(Oxford University Press, 2000, ISBN: 0198292279), “investors ... hardly adopt the passive strategies expected of uninformed market participants by the efficient markets theory” (see also Behavioral Economics? by Tibor Machan).

Diversification, Risk and Value Investing

Concentration of decision-making, minimisation of price-volatility and diversification of portfolios remain mantras of the contemporary financial mainstream. Few advisors would dream of recommending to their clients a portfolio of securities that had not been “efficiently” diversified by a major funds manager, and few managers would construct portfolios without this attribute. Adherents to MPT believe that the chance that one can minimise risk improves as the number of stocks in the portfolio grows. Hence a portfolio of ten is better than one and a portfolio of one hundred is better than ten. Efficient diversification dampens the impact upon “performance” of severe fluctuations of individual securities’ prices. Managers know what often happens when investors open their statements and notice that the market capitalisation of their holdings has suddenly and unexpectedly fallen. Even investors who understand that such dips are normal may become grumpy and take their funds elsewhere.

The more efficiently diversified the portfolio, the lower the likelihood that the “performance” of any one security will influence the monthly statement. The better diversified the portfolio, in other words, the less the risk to the manager’s career. What is wrong with diversification? Up to a point – say, 15-20 securities in a portfolio – nothing. Up to a point, diversification is indeed beneficial. Beyond this point, however, it greatly increases the chances that the investor buys securities about which he knows (too) little. Philip Fisher wrote in Common Stocks and Uncommon Profits (John Wiley & Sons, 1958, 1996, ISBN: 0471119288) “it never seems to occur to [investors], much less their advisors, that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification.”

Similarly, Warren Buffett says he “can’t be involved in 50 or 75 things. That’s a Noah’s Ark way of investing – you end up with a zoo that way. I like to put meaningful amounts of money in a few things” (The Wall Street Journal, 30 September 1987). Mr Buffett’s criticism also cuts more deeply. He told Outstanding Investor Digest (8 August 1996) that “diversification serves as a protection against ignorance. If you want to make sure that nothing bad happens to you relative to the market, you should own [a bit of] everything. There is nothing wrong with that. It’s a perfectly sound approach for somebody who doesn’t know how to analyse a business.” If, however, “you are a know-something investor, able to understand business economics and to find ... sensibly priced companies that possess important long-term competitive advantages, [then] conventional diversification makes no sense for you” (Berkshire Hathaway Annual Report 1993).

To diversify far beyond 15-20 securities in one’s portfolio, then, is necessarily to lower one’s standards and to buy less discriminately. To do this, in turn, increases risk (in the sense that that term is commonly understood). John Meynard Keynes made many grievous errors in The General Theory (see, for example, Letter 51). But his attitude towards investment risk is sensible. “As time goes on, I get more and more convinced that the right method in investments is to put fairly large sums into enterprises which one thinks one knows something about and in management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence ... one’s knowledge and experience is definitely limited and there are seldom more than a handful of enterprises at any given time in which I personally feel myself entitled to put full confidence.”

Mr Buffett, concurring with Keynes, has added that if it raises both the intensity with which an investor thinks about a business and the margin of safety he demands before becoming its owner or part owner, then a strategy of mental and financial concentration may mitigate the risk that inheres in any investment operation. Clearly, then, value investors and advocates of MPT regard risk in mutually-incompatible ways. To a value investor, investment risk has nothing whatever to do with the volatility of the quoted prices of his publicly-listed holdings. Graham noted in Security Analysis: The Classic 1940 Edition (McGraw-Hill Trade, 2002, ISBN: 007141228X) that “the bona fide investor does not lose money merely because the market price of his holdings declines, and the fact that a decline may occur does not mean that he is running a true risk of loss. ... We apply the concept of risk solely to a loss which is either realised through actual sale, or is caused by a significant deterioration in the company’s [operations] – or, more frequently perhaps, is the result of the payment of an excessive price in relation to the worth of the security.”

As Mr Buffett put it in The Superinvestors of Graham-and-Doddsville, “sometimes risk and reward are correlated in a positive fashion ... [but the] exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the later case. The greater the potential for reward in the value portfolio, the less risk there is.” Mr Buffett continued: “for owners of a business – and that’s the way we think of shareholders – the academics’ definition of risk is way off the mark, so much so that it produces absurdities.” In 1974, for example, Berkshire Hathaway bought a substantial percentage of The Washington Post Company. The price paid for these shares implied that TWPC, considered as a whole, would fetch $80m if it were sold. Yet “if you’d asked any one of 100 analysts how much the [entire] company was worth when we were buying it, no one would have argued with the fact that it was [actually] worth $400m.” By Mr Buffett’s way of thinking, the price volatility of TWPC’s shares enabled him at a propitious moment to buy them at a fraction of a businesslike assessment of their value. In effect, he was buying assets widely valued at $1.00 for less than $0.20.

According to the financial orthodoxy, the price volatility of TWPC’s shares made their purchase a risky proposition – indeed, the greater these shares’ price volatility and the lower their purchase price, the riskier the investment. As Buffett concluded incredulously, “with that, [the academics] have lost me.” The market capitalisation of Berkshire’s stake in The Washington Post Company has subsequently fluctuated wildly – from $10.6m in 1974 to $150m in 1984, $419m in 1994 and $1.4 billion in 2004. Graham and Buffett emphasise that successful investment entails the identification of good (and preferably excellent) businesses, the cautious estimation of their value and the payment of bargain prices relative to value. Successful investing requires that one make reasonable assumptions about companies and their prospects. These assumptions are fraught with uncertainty and error; accordingly, risk – that is to say, the likelihood that certain desired events do not occur, or that undesirable events actually do occur – unavoidably accompanies any investment operation.

For a value investor, four sets of risks are most noteworthy. The first is the possibility that a good (on the basis of its past and current operations) business becomes a mediocre one; the second is the possibility that an unreasonably high price is paid for a good business (or that the purchaser makes unduly optimistic assumptions about its prospects); the third is the possibility (perhaps as a result of mistaken or insufficiently thorough research) that what the investor believes to be a good business is actually a mediocre or poor one; and the fourth is the possibility that widely-accepted fallacies and falsehoods – which in Mr Buffett’s view include MPt – are accepted as facts. Two corollaries follow from these points. First, investment risk has at least as much to do with the attitude, disposition and behaviour of the investor as it has with the characteristics of the investment. Like value, in other words, risk is a subjective phenomenon (see Letter 52). Second, something which is incessantly cited as a risk to investors, namely the day-to-day, week-to-week and month-to-month volatility of market prices, is no such thing. Quite the contrary: if understood properly, short-term volatility can present opportunities and dispense rewards to true investors.

Diversification: An Austrian View

In sharp and refreshing contrast to the mainstream is Frank Shostak’s excellent article Diversification: An Austrian View. Interestingly, it uses words that a Grahamite value investor would roundly applaud. According to Shostak, “the MPT framework gives the impression that there is a difference between investing in the stock market and investing in a business. However, the stock market doesn’t have a ‘life of its own.’ The success or failure of investment in stocks depends ultimately on the same factors that determine the success or failure of any business. Consequently an investment in stocks should be regarded as an investment in business as such and not in stocks. By becoming an investor in a business an individual has exercised an entrepreneurial activity. In other words he has committed his capital with a view to supply the most urgent needs of consumers.”

In the real world, entrepreneurs and capitalists strive to invest capital such that it produces the goods and services (or produces the capital goods that in turn produce the consumer goods) that are most highly sought – and hence valued – by consumers. He who can best satisfy consumers’ most urgent needs either directly or through more “roundabout” processes generates profits; and it is profit and profit alone that guides entrepreneurs. Investors strive to maintain and expand profits – and not, as MPT asserts, to minimise risk. An entrepreneur’s return on his investment is therefore determined not by how much risk he assumes but rather by the extent to which he anticipates and serves consumers’ wishes.

According to Shostak, “the fact that entrepreneurs appear to be practicing diversification by investing in various businesses over time doesn’t necessarily mean that they do so in order to reduce their investment risk, they may diversify in order to boost their chances of earning profits. The moment the primary consideration of investment becomes the reduction of risk rather than the attainment of the highest possible profit, then all kind of strange decisions may emerge. For instance, strictly following MPT, one may deliberately invest in an asset that offers a negative return in order to reduce the overall portfolio risk. However, no sane investor deliberately chooses a badly performing investment. It is only the emergence of conditions not properly forecasted by the investor that leads to a bad investment.”

Echoing Buffett and Fisher, Shostak notes that “in an attempt to minimise risk, practitioners of MPT tend to institute a high degree of diversification. However, having a large number of stocks in a portfolio might leave little time to analyse the stocks and understand their fundamentals. This could raise the likelihood of putting too much money in bad investments. This way of conducting business would not be an entrepreneurial investment but rather gambling.” Shostak concludes “proponents of modern portfolio theory argue that diversification is the key to the creation of the best possible consistent returns. We argue that one must focus on the profitability of the investments in a portfolio, before one considers their contribution to the portfolio’s diversification. Consequently, whilst we agree with the general principle of diversification, we believe that the profitability of an individual investment should be the primary consideration for the investor.” 

Blowing the Whistle on the Pollies and Profs

What, ultimately, is wrong with modern portfolio theory? Mr Buffett once told his shareholders “correctly observing that the market was frequently efficient, [the efficient markets enthusiasts] went on to conclude incorrectly that the market was always efficient. The difference between the propositions is night and day.” The problem is that, like the contemporary mainstream economics that subsumes and inspires it, MPT dismisses individuals, subjectivism and entrepreneurship to the sidelines (see in particular Shostak’s In Defence of Fundamental Analysis: A Critique of the Efficient Market Hypothesis, E.C. Pasour’s The Efficient-Markets Hypothesis and Entrepreneurship and Efficient Markets versus Value Investing).

To MPT’s adherents, things like flesh-and-blood individuals, their inspirations, values, plans, time preferences and the businesses they found and build, may just as well not exist. There are only aggregates, omniscient and benevolent governments, arid models, lifeless data and stylised behaviour. Hence there is simply no room for the inspired (or, for that matter, misguided) capitalists, investors and businessmen whose behaviour does not conform to the straightjacket into which MPT confines them. If MPT is correct then advanced mathematics and other technical expertise, computers and automatic pilots are essential – and historical perspective, qualitative judgment and cautious analyses of individual businesses, their operations and prospects are pointless. If it is correct then the confident “rocket scientist” armed with a Ph.D. is indispensable and the sceptical businessman-investor with skin in the game and a successful track record, like Graham or Buffett, is superfluous. MPT attenuates the individual, the particular case, common sense and tacit knowledge; and it accentuates the abstract, aggregate, technical and esoteric. In so doing, it encourages centralised decision-making in the hands of a technocratic élite.

In a Keynesian world, in turn, élites of any stripe tend to be arrogant, error-prone and insulated from the consequences of their regular and occasionally mammoth blunders. Accordingly, MPT, as the Crash of 1987 and The Great Bubble amply demonstrated, actually facilitates moral hazard (i.e., risk-seeking behaviour), turmoil and the destruction of capital. Even élite decision-makers occasionally seem to agree: according to Timothy Geithner, president of the Federal Reserve Bank of New York (The Wall Street Journal 15 April 2004), “the same developments in financial technology that have improved the sophistication of risk management and the ability to transfer risk can ... at least for short periods of time amplify large moves in asset prices.”

We have academics to thank for MPT, business schools to thank for academics, universities to thank for business schools and politicians to thank for universities. Mssrs Buffett and Munger have for decades and to various degrees castigated them all. Living standards owe little or nothing to either institutionalised research and development or “education” – particularly the bastardised (i.e., tax-subsidised) variety imparted in contemporary universities and business schools. For individuals, education (in the proper sense of the term) is indeed priceless stuff, and in particular the private returns to self-education can be great.

But what about the endlessly-trumpeted “returns to society” that allegedly derive from mass education in state-directed institutions? These are much lower than academics and politicians blithely and relentlessly assert. Indeed, like the results of most activities organised and financed by politicians, the returns to taxpayers are much more likely to be negative than positive. Exacerbating the distemper of our times, then, are some false, destructive and just plain crazy notions that are zealously propounded by powerful politicians and their court intellectuals. These ideas, whether expressed in their military, economic or financial variants, commandeer others’ property, centralise decision-making in élites’ hands and generate interventionist policies. These élites’ unspoken motto is “we’re smarter than you and we know better than you do what’s good for you; so shut up, step aside and let us work our wonders.” Vastly overestimating their intelligence (and underestimating the brains of the benighted), flouting the laws of human action and lacking any meaningful feedback mechanism, this arrogant élite’s policies almost always lead to tears (see in particular Bertrand de Jouvenel, The Ethics of Redistribution, Liberty Press, 1952, 1990, ISBN: 086597084; Charles Murray, Losing Ground: American Social Policy, 1950-1980, Basic Books, 1981, 1995, ISBN: 0465042333; Thomas Sowell, The Vision of the Anointed: Self-Congratulation as a Basis for Social Policy, Basic Books, 1995, ISBN: 0465089941; and Jim Powell, FDR’s Folly: How Roosevelt and His New Deal Prolonged the Great Depression, Crown Forum, 2003, ISBN: 0761501657).

The policies of the best and the brightest produced disasters in the 1970s – not to mention the 1930s, 1940s, 1950s, 1960s, 1980s, 1990s and during The Great Bubble – and, given this sorry track record, there are ample grounds to fear that they are also doing so today. Among many other things, they have spawned business schools in which perverse incentives thrive and pernicious attitudes proliferate. If a patriot is one who wishes to defend his country against its politicians and their sycophants, then it is high time that one of Her Majesty’s loyal Australian patriots compiled a lengthy charge sheet and blew a loud whistle against the harmful and tax-subsidised shenanigans – of which modern portfolio theory, a harmful legacy of the 1970s, is a prominent example – in its universities and business schools.

Chris Leithner


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