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The Modern Portfolio Theory Flat Earth Society

“I’d rather be vaguely right than precisely wrong.” That’s my favorite quote from British economist John Maynard Keynes; it took me a long time to truly appreciate its importance. Math and physics are rooted in equations that spit out precise answers; vagueness there is dangerous — for the right reasons. That is why they are called exact sciences. Investing, despite being taught as an almost exact science, is far from it. It is a craft that falls somewhere between art and science.

A few months ago, while analyzing a company, I asked an executive of a Fortune 500 company what his company’s cost of capital was. The answer I got was, “Well, the beta of our stock is 0.6, and our cost of debt is 3.25 percent, so the cost of capital is 6.35 percent.” Warren Buffett was asked about Berkshire Hathaway’s cost of capital at his recent annual meeting. The Berkshire CEO’s answer was vague — “It is what can be produced by our second-best idea” — but it was right.

I am often asked by students if I recommend studying for the Chartered Financial Analyst designation. In the past I always responded with an unequivocal yes. There were many reasons for that: The CFA charter is like getting a master’s degree in finance and investing at a fraction of the cost, and it is valued just as much. Employers like it because it is standardized, and they know what you had to learn. The CFA covers a lot of material, from ethics to financial derivatives.

Lately, however, I have found myself qualifying my yes answer. If you are looking to do the CFA for self-education, I wouldn’t bother. The reason for that is simple: The CFA curriculum spends too much time on Modern Portfolio Theory (MPT). That is the nonsensical set of formulas used by the Fortune 500 executive to compute his company’s cost of capital. (I have to qualify this: I finished my CFA in 2000. Maybe the CFA curriculum has changed since then.)

I’ve been in the investment industry for almost 20 years. I have had thousands of conversations with other investors about stocks, but I have yet to have one conversation in which beta or Modern Portfolio Theory was mentioned as part of the analytical framework — not even once. You hear MPT and beta in the same sentence with other words such as “useless,” “theoretical” and “garbage.” If you were to ask what the beta of any company in my portfolio is, I would have no answer for you; I have simply never looked. But ask me about the return on capital or debt of any stock in the portfolio, and I’ll be right in the ballpark.

MPT — a Noble Prize–winning theory — has lots of flaws. Beta, a mostly random number, is sitting right in the middle of the calculation of MPT. The theory assumes investors are rational — no, that is not a typo. If you are not laughing, you should be: A recent study by Boston-based research firm Dalbar found that the average (rational) investor in U.S. stock mutual funds received an annual return of 3.7 percent during the past 30 years, significantly underperforming the funds in which they invested (they bought high and sold low), as well as the S&P 500 index, which returned 11.1 percent a year during that period. MPT defines risk as volatility, whereas rational people would say that permanent loss of capital is the real risk.

These are not all the flaws, but it would take too much time to go through them. The central flaw of MPT, though, is that it’s a theory with few practical implications. This analytical portfolio framework is used not by analysts or portfolio managers but only by academics and an army of consultants (neither group invests for a living). In other words, by studying MPT your brain cells have died for nothing.

Imagine you are living in the Dark Ages and the Greeks already proved that the world is round, but the world-is-a-ball theory is not being widely taught. So teachers, who rarely step outside the walls of their own institutions, confidently declare to their students that the world is flat, whereas those who meanwhile roam this wonderful planet more widely (let’s call them entrepreneurs and investors) know perfectly well that it is round. This is pretty much what is happening today with the divide between real-world and academic investment professionals.

If you learn anything by going to the Berkshire Hathaway annual meeting, it is the incredible power of incentives. Berkshire vice chairman Charlie Munger is big on that idea. Teachers will teach what is teachable; they’ll default to solving a mathematical equation (while stuffing it with arbitrary numbers for the most part), because that is what they know how to do. They can learn MPT by reading their predecessors’ textbooks, and therefore that is what they’ll teach, too. The beauty of MPT, at least from a teaching perspective, is that it turns investing into a math problem, with elegant equations that always spit out precise, albeit random numbers.

But please don’t tell anyone I said this, because as an investor I’d love for MPT to be taught starting in kindergarten. It would make my job easier: I’d be competing against imbeciles who still believe the world is flat. However, as a well-wishing person dispensing advice, I’d say, spend as little time as you can studying MPT.

Leave a Comment    (21)

  • POST

"This analytical framework is not used by analysts or portfolio managers..." or anyone that "invests for a living". It's "a theory with few practical implications."

I think Dimensional Fund Advisors would disagree.

Feb 12 2015 at 6:31 PM EST


To add to your dark age trivia Jerusalem was considered the center of the earth and the sun rose in the north "The orient" and went down in the south the mouth of the Med.

This is why when we Orient a map we always to this day put north page up.

Also like today not believing the earth was flat made you a heretic and which would put you in front of the inquisition to explain your belief.

May 20 2014 at 7:39 PM EST

Sandy Jack

The CFA Program curriculum is based on a rigorous industry practice analysis process and reflects important educational elements that employers wish to see in a qualified investment professional. In that sense, CFA Institute is a conduit that reflects, or channels, what industry thinks is important. The curriculum thus evolves over time and today incorporates many approaches to investing, including behavioral finance, goals-based private wealth management, and technical analysis. The curriculum certainly does not favor one approach over the other. The goal is to provide a well-rounded education in finance and Modern Portfolio Theory is a cornerstone (but not a capstone) of that education. In fact, almost any post-MPT framework relies on some variant of the "technology" of MPT as its foundation, including many of the goals-based investing frameworks that have emerged in recent years. An analogy from the physical sciences is that if you want to know how to calculate the arc of a missile in the atmosphere, you begin with a model that assumes a vacuum and then make adjustments from there based on atmospheric conditions (including, of course, the all-important assumption that the earth is round.)

May 20 2014 at 5:03 PM EST

Stephen Horan, CFA, Managing Director and Co-Lead Education at CFA Institute

As someone who has read hundreds of books on investing and is sitting for the CFA Level 1 exam three Saturdays from now, I could not agree with you more. The concepts of Modern Portfolio Theory are so hard to wrap my brain around. And it is not because the theory is so complex but that it is so illogical. But as you wrote above, for my benefit, I certainly hope they never stop teaching MPT in college. It does nothing but make it easier for me to find dollars selling for fifty cents.

With that said, I will have to suspend my common sense for one Saturday to hopefully pass an exam that I've begun to question whether I should even be sitting for.

May 19 2014 at 11:44 AM EST


Volatility IS the correct risk measurement when you reference the results of the Dalbar study. The human brain of course fears permanent loss of capital and being wiped out. However, a diversified portfolio of mutual funds which is how the majority of retail investors invest has absolutely NO chance of going to zero. That would mean all positions, thousands, that comprise the portfolio would all go bankrupt. But, when volatility hits our fears become irrational and we feel it will all go to zero, hence we sell at the wrong time. Insuring that we will underperform radically. By controlling volatility you improve the odds of investors sticking through the rough times and at least capturing a greater percentage of the returns the market is offering.

May 18 2014 at 11:32 AM EST

Dirk Digler

never let a good story get in the way of facts.

May 18 2014 at 7:54 AM EST

Bob Roark

I feel that our writer is getting rougher and rougher on the tongue with every other article. No need to flower words with imbeciles and idiots. The point of the article is clear enough.

May 18 2014 at 7:16 AM EST

A friendly observer

Buffet, among very others, largely makes his own markets.

For the rest, for Gawd's sake, even Safeway supermarket prices aren't predictable. How could financial markets ever be?

May 17 2014 at 4:43 PM EST


Are you aware that it is not possible for anyone to "buy high" unless someone else is "selling high"? And the same applies to buying and selling low? So, it is simply not possible for the average transaction to consist of buying high and selling low, no matter what Dalbar claims to have discovered?

May 17 2014 at 12:38 PM EST

Jerome Berryhill

Not all college finance and investment lecturers are/were brain dead on the topic of MPT. Some of us were just schizophrenic, teaching it by day as required while totally ignoring it in our own investment selection process.

May 17 2014 at 10:03 AM EST


You call this a serious article? This is a rather weak and unoriginal rehash of ideas we've all read before, criticizing a general framework for examining investments in the context of a broader market opportunity set. You could at least get your terms straight - "rational" and "efficiency" refer to the expectation of investors that greater risk should be compensated by higher returns. It has nothing to do with investors' penchant for emotion; the two are not necessarily mutually exclusive, unless your "scholarship" is limited to a quick review of finance textbooks, as yours seems to be. And your fascination with The Oracle smacks of both immaturity and a rather narrrow and amateurish perspective. Grow up. And stop making fun of people.

May 16 2014 at 4:35 PM EST

Stephen Campisi

Those that can, get CFAs. Those that can't, write articles about how useless it is.

May 16 2014 at 4:16 PM EST

Mary Sigler, CFA

interesting article but I too think you got the analogy wrong. You appear to be the flat earther denying the earth is round. On a small scale it looks like individual security analysis is the way to go (the Earth looks flat) on a larger scale you can see that MPT is a good representation of how things look (the Earth is round). Also, the Earth being round was the new theory replacing the flat earth theory. Your theory on securities selection is challenged by the MPT not the other way around. Observation (most people & professionals do not beat the market) shows that the theory is largely correct on a large scale. Does not mean you have to completely believe in efficient markets.

May 16 2014 at 7:13 AM EST


I was a broker for 23 years and I learned very quickly that the game is based on emotion and not finance. If one didn't, then they were out of the business in a very short time.
I loved your article which I found went straight to the point and exposed it clearly.
Barry S.

May 15 2014 at 5:59 PM EST

Barry Stephenson

True believers in MPT remind me more of Ptolomy and the epicycles--stretching credulity for explanations of anomolies and inefficiencies.

May 15 2014 at 3:37 PM EST



On practice, if you are going to value an investment or a company and you don´t want to use beta, what is the way you use to differentiate a risky business in order to compare?
Do you only put the risk in the variance of scenarios and discount every one at the same discount rate, or is there any way to account for the risk in the discount rate?

May 15 2014 at 2:17 PM EST

Mauricio Safra

OK, so MPTs assumptions do not hold. I guess by now everybody agrees on this. But nobody has shown a different way to estimate cost of capital. So the earth is actually round, but nobody knows how to measure its size.

May 15 2014 at 12:31 PM EST

J Dominguez

Your final sentence should have read that low cost of capital encourages risky behavior. Tech companies may tend to slack off when over capitalized after an ipo for example, but they don't stop spending.
Allocating capital efficiently is a risk aversive behavior.

May 15 2014 at 12:02 PM EST

Rick Drysdale

Great article, but Copernicus discovered that Earth wasn't the center of the universe, not that it wasn't flat.

May 15 2014 at 10:58 AM EST

Brian Mackey

Not a good example, it is a modern myth that scolars believed the world was flat. From Aristotle, it was known among scholars that earth was a sphere, even the radius was computed. Coloumbus also knew, but he was wrong about some details.

May 14 2014 at 6:18 PM EST


Buffet's answer is more accurate, although the Fortune 500 executive's answer is more responsible. My personal belief is a higher cost of capital ensures that a company allocates capital efficiently. Perhaps that could be the reason why tech companies tend to slack off once they become public. Low cost of capital, counter-intuitively, encourages risk aversion.

May 14 2014 at 9:57 AM EST