Modern Portfolio Theory (MPT)

The most common investment philosophy theory which is taught at universities and adopted by fund managers has been based on the principals of modern portfolio theory. This theory is has been developed by academia and adopted by main stream larger fund managers. 

However despite this support for the philosophy the principals and philosophy has publically criticised by the most successful investors Warren Buffet and Charlie Munger as being fundamentally flawed. These two value investors have over time attempted to re-educate these groups on the inadequacies of MPT and attempted to introduce a new philosophy of value investing, which was pioneered by Benjamin Graham.

Instead of embracing this philosophy which has been successfully developed by Buffet and Munger, the academia and funds management industry at large have categoriesed these to successful investors as a  freak of nature. Interestingly Buffet and Munger have illustrated the success which they have achieved been replicated by other investors over the decades.

So what are the principals of Modern Portfolio Theory? Essentially they can be summarized in the following format:

1.       Each asset class has a varying level of volatility (market movement). This means how much an asset moves up in value and down in value.

2.       You should hold a basket of all these asset classes in varying weightings. Otherwise known as a diversified portfolio across all asset classes all the time.

3.       The weightings will be adjusted according to your return which you are seeking. This means higher volatile assets classes are expected to produce higher returns.

4.       By holding this weighting and diversification over the long term, when some assets are negative or poor performing, other assets are performing strongly or positive. Asset classes offset each other during periods of uncertainty or market chaos.

So broadly you can see these principals being adopted by the community at large which are:

1.       Holding a diversified portfolio across all asset classes

2.       Holding varying weightings of these assets in your portfolio at all times.

What is not publically known about this philosophy is that it makes 2 assumptions:

1.       The investors are always rational

2.       Markets are always efficient

It goes a little further to say that all the known information about the stock market, economy and the underlying company are priced in at any given time to an individual share or an asset class at large.

In our opinion these assumptions are clearly wrong and the reason being is the founding principal of value investing is identifying opportunities to purchase an investment which is trading at well below its fundamental value. For this to occur the investors need to be irrational and the market has to be inefficient, otherwise the philosophy could not exist. The reality is that value investors since the start of this philosophy have continued to prove that not only can these opportunities be identified, but this can be maintained consistently over decades of investment.

The other concern is the basis of diversification across all asset classes. The philosophy has made the assumption that every single day of every single calendar year the mix of assets classes is perfectly ideal for investment. 

In our opinion and that of value investors this philosophy is again fundamentally flawed. Why would we purchase an asset within a sector just for the sake of diversification, particularly if the sector is overvalued based on its fundamental value.   In our opinion Buffet describes diversification as a means and a way to compensate for ignorance. We would only invest in an asset classes if it was presenting opportunities that are compelling for investment. Interestingly if you review Buffet’s top holdings in his portfolio the principals have definitely not been adopted according to MPT:

1.       American Express Company

2.       The Coca-Cola Company

3.       ConocoPhillips

4.       Johnson & Johnson

5.       Kraft Foods Inc

6.       POSCO

7.       The Procter & Gamble Company Sanofi-Aventis

8.       Swiss Re

9.       Tesco plc

10.   U.S. Bancorp

11.   Wal-Mart Stores, Inc

12.   The Washington Post Company

13. Wells Fargo & Company

 

Buffet believes to hold a concentrated portfolio of high quality shares which can be closely monitored and managed, we too agree with this philosophy and principals.

When looking at investing, sectors or theory it is always the assumptions which are critical, for example in the sub prime debacle it was the assumption that property in the US always goes up, so if they default we can just sell the property. Well presently property values in the US are 50% below their peak and unlikely to recover back to the same level for a number of years, so the banks can’t just sell the property to get their money back in full and the assumption utilized has caused market chaos of gigantic proportions. With MPT it is the assumptions which have been outlined above which are fundamentally flawed and that is why JPM Investment Group will only invest in sectors which are presenting compelling value to our clients and embrace the philosophy of value investing in our portfolio construction.