Return on Investment

Potemkin Village

In my opinion Modern Portfolio Theory is a Potemkin Village. What does that mean?

In the 1700s Catherine the Great, ruler of Russia, invited a number of foreign dignitaries to visit Russia. But in viewing the countryside she saw the villages of Russia were unimpressive to say the least. So, she commissioned Field Marshall Griorgi Potemkin to build all new villages to give the impression that the citizens of Russia lived a comparatively good life. It was completely illusionary. A “Potemkin Village” is something made to look elaborate and impressive but has no substance at all.

Modern Portfolio Theory sounds like it is new and rational and “modern.” In fact the concept goes back to Irving Fischer an economist who, in the 1920s, conceived the idea of a “rational market.” A rational market which should obey economic “laws.” Those laws, once discovered, would govern the world of economics just as the laws of physics and chemistry and biology governed their respective fields.

In the late 1950s, Harry Markowitz opined that the movement in the price of a stock was related to two factors – the relative value of the company itself and the movement of the stock market. Markowitz labeled the two by the Greek letters “alpha” and “beta.” Beta was the impact of stock market movements and alpha the impact of the company. We hear financial analyst, money managers, news commentators, and financial advisors use those terms frequently. According to the economists and the financial “experts,” those terms describe the price of a stock and even a stock portfolio at any given time or over a given time period.

Art Cashin modernized what Bernard Beruch said almost 100 years ago: “The stock market is a perception market. Any time it believes 2 + 2 = 5, it will pay 4 ¾ all day long.” My corollary is that any time the market believes 2 + 2 = 3, it will sell at 3 ¼ all day long. We have only to look back at 1999 during the dot-com days to see the rush to pay 4 ¾ for the market all day every day. At the same time, looking back to 2008-09, we see the rush to sell at 3 ¼ day after day. Neither case was rational.

Modern Portfolio Theory sounds rational and logical. In fact it sounds good. When talking to financial advisors who espouse that they follow Modern Portfolio Theory, it sounds like they are on the cutting edge, and those of us who do not believe must believe in the “Old Portfolio Theory,” if such exists. It is the classic Potemkin Village. It is elaborate with its “efficient frontier” explanation of risk and reward. It is impressive with “asset allocation” to reduce volatility (and thereby risk). It has that feel-good feeling a rational, reasonable, and logical market. History shows it is an illusion.

Eugene Fama, who shared the Nobel Prize in economics in 2013, is a strong believer in the Efficient Market of Modern Portfolio Theory. His studies of money managers showed fewer than 7% do as well or better than the market over the longer term (5-10+ years) when fees are considered. I am happy to be one of those who has done better (check my performance page on this website for my figures). Fama is not alone in his studies and findings of money managers. Charles Ellis (Winning the Loser’s Game) found less than 10% of money managers doing as well- or better than the market in the 1980s an d 1990s.

The premise of Ellis’ book was for investors to set their expectations lower. That was the way to “win at the loser’s game.” I disagree. Investors should take a lesson from professional sports – football, baseball, soccer, or basketball, take your pick. If the manager is a loser, fire him and go search for a winner. The Department of Labor reports that a 1% reduction in performance over 20 years will reduce a nestegg by 17%! Think of what 3% or 4% or 5% will do. Let me repeat, if the manager of your portfolio is not beating the benchmark over the longer-term, fire him and find a manager who does. If you are managing your own stock portfolio and not beating the S&P 500 over the longer-term, fire yourself and hire someone who is likely to beat the S&P 500 over the longer-term.

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