“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.