# The Modern Portfolio Theory Flat Earth Society

## During my time at the Berkshire Hathaway annual meeting, I was reminded that investors would be better off not wasting their time studying Modern Portfolio Theory.

“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.