MPT – Strike 1: Investors Are Rational
A friend of mine told me that I should look at the Modern Portfolio Theory (MPT) for some ideas on what to write about. Boy was he right. But first, what is MPT?
MPT is a theory of investment which attempts to maximize a portfolio’s expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. It is also a form of diversification (and you know how I feel about that (if not read my post on diversification)).
MPT is best explained by using a mathematical model, which, in my own opinion, is a bunch of baloney. The only mathematics you need to evaluate companies or stocks is simple adding, subtracting, multiplication and division. That’s it. Now the model works in theory, but in the real world, where there are no save points, it doesn’t even come close to working. This is due to the FACT that it makes a few very grave assumptions. So part one of our journey through the pitfalls of MPT starts now with the assumption that………….
INVESTORS ARRRRRRRE RATIONAL
One of the assumptions that enables MPT to work (in theory) is that investors are rational. I find great difficulty in believing this to be true due to the simple fact that investors are not any different from other people. Investors are people; plain and simple. Now how many people do you know who are completely rational? Take a few pauses here to really think about that……………keep thinking……….
Probably not that many right? And that is because the majority of people (please do not take offense here) are too emotionally driven to be rational. I know you’re not though.
So now how can investors be rational? Are they some sort of superior being that has evolved to totally abide by the rules of logic and circumstance and admonish most, if not all, of their emotionally weak mindset? Of course not. The majority of investors are not rational. They can be greedy, overzealous, and sometimes frightened when their favourite stock takes a plunge.
As an example let’s look back a few years at some irrational investors who were buying technology stocks. And remember any smart individual (who knows at least a little accounting) could see that the majority of “tech” stocks were grossly overvalued at this time, even though they were very popular.
1. In 1999, Alexander Cheung of (what once was) Monument Internet Fund, after earning 117.3% in the first 5 months of the year, claimed that his fund would gain 50% over the next three to five years and would achieve an annual average of 35% over the next twenty years. Now is he rational? Well, considering most of the fund’s portfolio was comprised of internet stocks which were grossly overvalued, I’d say no he isn’t rational. He got caught up in the market mayhem of internet stocks. Another point to look at is that the highest 20 year return for any mutual fund in history was about 25.8% per year (performed by the great Peter Lynch). Peter’s performance during that period turned $10,000 into more than $982,000, and yet Cheung was saying that he could turn it into over $4,000,000! Obviously that is ridiculously overoptimistic. And here is the point….investors bought it. These “rational” investors threw more than $100,000,000 into Cheungs fund over the next year. By the end of 2002, that $100,000,000 was worth about $20,000,000. A loss of 80%.
2. Alberto Vilar of Amerindo Technology Fund, after a whopping 249% return for 1999, ridiculed anyone who doubted that the internet was a perpetual money making machine: “If you’re out of this sector, you’re going to underperform. You’re in a horse and buggy, and I’m in a Porsche (personally I loled there). Clearly Mr. Vilar was not rational in saying this, as the backbone of the economy at the time was the brick and mortar companies (companies with tangible assets). So clearly this investor, who ran a multimillion dollar mutual fund, is not rational. To showcase this, if you had invested $10,000 at the end of 1999 you would have about $1,195 left by the end of 2002. Makes you sick doesn’t it?
3. James J. Cramer, a hedge fund manager, proclaimed in 2000 that Internet-related companies “are the only ones worth owning right now.” These “winners of the new world are the only ones that are going higher consistently in good days and bad.” Oh man. As with the above examples, he isn’t looking at what these companies are worth. He is looking at the price of the stock. Sorry James, you’re being branded as irrational. By year end 2002, one of the 10 companies in the fund went bankrupt, and a $10,000 investment would have shrunk to about $597.44. That is freaking scary. I’m not sure which new world James was referring to here….oh wait, an irrational world, where people pay for overvalued stocks that won’t make them any money.
The majority of investors are obviously not rational and as long as people are guided by their emotions they never will be.
Strike one MPT. Swing and a miss. The first assumption that investors are rational does not stand up for modern portfolio theory to work.
MPT – Strike 2: Markets Are Efficient
Ready for the next blunder that Modern Portfolio Theory assumes? Are you?!?! Well get ready for the next big assumption that MPT makes which is……………………………
MARKETS ARRRRRRRE EFFICIENT
What this means in that in order for MPT to work the model assumes that markets are efficient, meaning (more or less) that at any given time the price of a stock reflects what a company is worth based on all readily available public information and that prices instantly change to reflect new public information. In very simple terms efficient markets are saying that the market is a weighing machine. Stock prices accurately reflect, at any given moment, what a company is worth.
What all investors need to understand is that the market is only a weighing machine (and only sometimes) in the long run. In the short run, it is a voting machine, and a poor voting machine at that. There will be all sorts of price discrepancies in the short run due to, overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing.
And if markets were efficient there would be very little money to be made, as companies would never become undervalued nor overvalued. Furthermore there would be zero arbitrage opportunities (taking advantage of a price difference between two or more markets). But let’s look at some examples of a few market inefficiencies.
1. The 2000 – 2002 financial crisis. Things were going so well in the stock market before 2000. The market was reaching new highs and people were making money. But of course we know that the market was grossly overvalued at this point. By believing in this idea that markets are efficient, financial leaders were inconsiderate to the chronic underestimation of the dangers of asset bubbles breaking. This inevitably led to one of our great recessions as the market corrected itself.
2. Lululemon at its current price of around $60 is disgustingly overvalued. It is currently trading at over 60X what it is earning. Meaning that for every dollar you put into it you will earn, as an owner of the business (in theory), less than two cents on that dollar. Even its price to book ratio is huge at about 20X, meaning that even if the company liquidated for every dollar that you put into it right now you would only get back about five cents! Now don’t get me wrong Lululemon is an amazing company, but the current price that some people are buying into it at right now is extremely overvalued. Its prospects and growth don’t even justify a price this high! Even the average price to earnings ratio for the industry is only about 27X!! So even if we use this average (although this is still very overvalued) it should be trading at about $25. But in my opinion that is still too high. $15 or $20 would be more understandable. There is no safety of principle with Lululemon at its current price, and if the market were efficient, the price of Lululemons stock would be much lower. (Please note that when I originally wrote this Lulu was trading at about $120, however recently they did a stock split so the share price is halved. The ratios are the same however.
3. A stock at its current price of around 2.25 is disgustingly UNDERvalued. The company sells linen and yarn in China, and has both excellent management and fantastic prospects. What is more interesting to note is that it should be trading at about $18.00 based on some calculations that I have done. Its current EPS for the first quarter of 2011 was a whopping $0.46! We can also safely assume that this number will continue in subsequent quarters, as their business is not cyclical or seasonal, meaning they should finish the year with an EPS of about 1.84. That means the P/E ratio is only 1.2X! This means that if you were to buy today you would make back (as an owner) more than half of your initial investment in one year. Furthermore, the company is poised for growth, as it plans to take over other companies in the surrounding area, and also receives some unique help from the Chinese government. So why the price discrepancy? Who knows?! The point here is that the market is not efficient. If it were, this company would be trading at a price much higher than what it is currently trading at.
So there are three examples on how the market is not efficient. Obviously we would need only one to disprove this assumption, but three really drives the point home. And of course there are many other examples out there, but we’ll stick with these ones for now.
Strike two MPT. The second assumption that the market is efficient does not stand up for modern portfolio theory to work.
“Here batter batter! Swing batter batter!”