Print the page
Increase font size

Posted November 28, 2021

Sean Ring

By Sean Ring

Modern Portfolio Theory: Part II

  • Last Wednesday, I laid out the history of MPT.
  • But I forgot Thursday was Thanksgiving in the States!
  • So today, a little review and then the concluding part of the MPT piece.

Happy Monday!

I hope you had a lovely weekend.

Let me apologize for stretching a two-parter over five days.  You see, Agora shuts its doors Wednesday evening for the biggest bar night in The States.

Since I’m in the Fat Eastern Colonial Office, I totally forgot there was a holiday.

I’m sure you stuffed yourself silly with turkey, stuffing, cranberry sauce, and pumpkin pie.

As you come out of your food coma - yes, Michigan did actually beat Ohio State while you were under - I’ll reintroduce modern portfolio theory and add its assumptions and arguments against it.

A Quick Review

Last Wednesday, I started to answer a question about MPT, or Modern Portfolio Theory.

The theory permeates all of finance and is especially important to fund managers and the banks that serve them.

The goal of portfolio theory is simple: maximize a portfolio’s return for a given level of risk.

To quickly elaborate, if a portfolio with a 10% standard deviation (or risk) can earn a 12% return, we prefer that to an 8% return.

It’d be irrational to invest in the 8% portfolio because we can earn 12% for the same level of risk (10%).

That’s pretty simple stuff.  And, of course, it makes sense.  Why would you ever prefer less to more when you’re taking on risk?

But what undermines the theory is its assumptions.

Let me lay them out for you.

MPT’s Assumptions, Finance’s La-La Land

Theorists make assumptions when they’re mathurbating.

Ahh, sorry.  New word.  Or portmanteau, to be specific.

The Urban Dictionary defines Mathurbation as

The art of substituting actually interesting content with complex-sounding but actually superficial math. Might bring some degree of arousal for the one performing it and some inexperienced and simple-minded spectators.

Example: Sannilkov's entire research has absolutely no contribution to science, it is just mathurbation.

Now that that’s out of the way, let’s get to the assumptions Markowitz made to get the math to work.

Asset returns are distributed normally.

Right off the bat, we have a ridiculous assumption.  Sure, height, weight, and shoe size are normally distributed.  But no returns anywhere in finance are normally distributed.

It’s little wonder why Nassim Taleb called the bell curve (or the standard normal distribution) The Great Intellectual Fraud in Fooled by Randomness.

The investor is rational and will avoid all unnecessary risks.

This one isn’t so bad, but it does assume the investor knows all the risks and, thus, can avoid them.

Investors will give their best to maximize returns for all the unique situations provided.

We know this simply doesn’t happen.

The largest investors rarely do this at all.  Pension funds, insurance companies, sovereign wealth funds, and endowment funds routinely sell calls against their portfolios to smooth out their returns.

High net worth individuals’ first priority is asset protection, not return maximization.

All investors have access to the same information.

Dearie me.

Sure, we can access stock data, charts, and news better than we ever could.

But do I get invited to dinner with Dalio, Fink, or Schwarzman?


And if you don’t think dinner or golf matters, let me remind you Alan Greenspan made his “Irrational Exuberance” comments at the Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research, in Washington, D.C., on December 5, 1996.

I woke up the next day wondering why the market tanked.

The people at the dinner doing the tanking clearly didn’t.

Investors don’t consider tax and trading costs when making decisions.

Taxes are most certainly taken into account in the States and other countries with a capital gains tax.

Where there’s no CGT, it’s obviously less of an issue.

Are trading costs accounted for now that it’s practically free?  Probably not.

All the investors have the same view on the expected rate of return.

Again, I think not.

Sure, investors have similar views on the markets.  But if we all had the same view, no trades would take place.

A lone investor is not sizeable enough to influence market prices.

BlackRock is.  To be fair, most aren’t.

Investors can borrow unlimited capital at the risk-free rate.

Usually ridiculous, this feels awfully true at the moment.

In fact, so much capital is available to institutional investors, banks have to redeposit their excess reserves - the stuff they can’t loan out - at the Fed every day.

And they earn - their word, not mine - interest on it!

It’s about as preposterous as it gets, but that’s another conversation.

Should You Employ MPT?

Ok, that’s not fair.

But Taleb further destroyed MPT in his book Antifragile - on my Rude Reading List - by alerting us to the fact that MPT relies on volatility and correlations remaining constant over time.

It’s plainly ridiculous.  Here’s an excerpt:

I noticed as a trader— and obsessed over the idea— that correlations were never the same in different measurements. Unstable would be a mild word for them: 0.8 over a long period becomes −0.2 over another long period. A pure sucker game. At times of stress, correlations experience even more abrupt changes— without any reliable regularity, in spite of attempts to model “stress correlations.”

He goes on:

Note one fallacy promoted by Markowitz users: portfolio theory entices people to diversify, hence it is better than nothing. Wrong, you finance fools: it pushes them to optimize, hence overallocate. It does not drive people to take less risk based on diversification, but causes them to take more open positions owing to the perception of offsetting statistical properties…

Ok, that’s the man himself speaking.

What does that mean for you?

Buffett… or This Guy?

No one can be Warren Buffett.

Despite his folksy self-deprecation, there’s only one Warren Buffett.  And there will only ever be one Warren Buffett.

Sure, read every one of his annual reports.  It’ll make you a more thoughtful investor.

So while MPT is not necessary to follow, Buffett is out of everyone’s reach.

Now let me introduce you to a man who bucked all the investing trends, kept a low profile, and is respected by all.

His name is Tony Deden, and he’s the Chairman of Edelweiss Investments.

Tony was an early supporter of Ron Paul and is an avid follower of the Austrian School of Economics.

I met Tony years ago at a conference.  Great guy - I had no idea who he was.

No, I don’t know him well.  And he certainly wouldn’t remember me.

What separates Tony from the rest of the fund managers is his duty of care to his clients.

I found this fantastic blog post on about Tony and his philosophy.

Reading it and understanding how he does business will make you do business better.

Heck, I wish I had found it sooner.

Tony rejected MPT long ago.  You’ll see why in this post.

Please read the post after you’re done reading this.  It’ll make you a little bit better today.

Thanks once again to Ed Kelly for his MPT request.  I hope I did it justice.

Until tomorrow.

All the best,


Two is One and One is None

Posted September 29, 2022

By Sean Ring

Someone returned my passport yesterday. I felt naked without it.

Sabotage of the Century!

Posted September 28, 2022

By Sean Ring

A naughty political actor blew up the Nordstream pipelines.

The Ugly Tree is Out of Branches

Posted September 27, 2022

By Sean Ring

The bond market is telling equities to get out.

Giorgia On My Mind

Posted September 26, 2022

By Sean Ring

Meloni will be Italy’s first woman prime minister; the Pound gets pounded; Dutch MP red pills his own Parliament.

The BoJ Blinks… Or Did It?

Posted September 23, 2022

By Sean Ring

The Bank of Japan won’t be the only central bank to intervene.

Biden, Powell, and Putin Make the News All Bad

Posted September 22, 2022

By Sean Ring

A fumbling US president, a bumbling Fed chief, and a stumbling Russian president walk into a bar…