The Limits of Modern Portfolio Theory - Do Investors Understand What They Own?

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Noobvestor
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The Limits of Modern Portfolio Theory - Do Investors Understand What They Own?

Post by Noobvestor » Sun Apr 22, 2018 1:33 am

The Limits of Modern Portfolio Theory by Steven D. Bleiberg in Barron's

It now dominates investing—and as a result, many equity investors no longer understand the companies they own.
Link: https://www.barrons.com/articles/the-li ... 1523636363

I found this to be an interesting way of rethinking the role of indexes over time. What does it mean that we are now focusing on performance of an index, or relative to an index, or based on factors of large groups of stocks, rather than the underlying businesses?

Excerpts:
What is a stock? Fifty years ago, the answer was simple: Shares represent ownership of a business. Then MPT came along and told us that individual stocks were really just a statistical cog in a portfolio, of interest only for their expected return and volatility. The main thing that mattered was a stock’s level of "systematic risk" ... and beta.
Basically, we thought about stocks as shares of businesses.
Today, when looking back at a stock’s return, we attribute that performance to its factor exposures, and show how the various “factor returns” drove the stock. But this is getting things precisely backward. As an investor from 1968 could tell us, stocks do well or poorly because the underlying businesses do well or poorly. After the fact, we can use stock returns to derive a set of factor returns, but it is a mistake to view the factor returns as if they have an independent existence, driving the returns of individual stocks as if in a vacuum.
So by focusing on performance as a function of the factors, not a business, we maybe lose sight of the real picture.
What is the role of an index? Fifty years ago, an index was just a measure of overall market performance. But under MPT, an index represents the optimal portfolio. To reach that conclusion, one has to assume that we all agree on how to define and measure risk, which is unrealistic. The logic of indexing ignores the fact that not all businesses are worth owning, and simply says “buy them all.”
More and more, in addition to the index tracking the market, the market (or at least: its participants) tracks the index.
What’s more, the use of indexing has had unintended consequences on the behavior of asset owners and asset managers; it changes the focus of both away from “which businesses are good businesses worth owning?” to “how do we look relative to the index"
Now, as a passive investor, I'm not going to go about asking what businesses are worth owning, just interested in others' thoughts.
"In the absence of clarity, diversification is the only logical strategy" -= Larry Swedroe

AlohaJoe
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Re: The Limits of Modern Portfolio Theory - Do Investors Understand What They Own?

Post by AlohaJoe » Sun Apr 22, 2018 1:47 am

It is an intriguing idea but I'm not convinced.

Did investors understand what they owned when they bought a mutual fund like Magellan?

Did investors understand what they owned when they paid into a pension fund?

Did investors understand what they owned when they bought a conglomerates like GE in the 60s?

Heck, do investors even really understand what they owned when they buy a bank or tech stock in 2018? Apple doesn't even report how much most of their products sell. Google doesn't tell you YouTube's revenue. And clearly no one understood banks or 2008 wouldn't have been as painful....

lazyday
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Re: The Limits of Modern Portfolio Theory - Do Investors Understand What They Own?

Post by lazyday » Sun Apr 22, 2018 4:24 am

To read most analyses of the ERP, you would think it is a mysterious force of nature, like gravity.
Blackrock seems to think so. (PDF)
The observed annual ERP was 4.3% from 1900 to 2016, ....
We assume an ERP of 4.0% in the future, which is
slightly lower than what the 1900-2016 average would
suggest. Investors are better equipped with tools to
construct globally diversified portfolios than they were 100
years ago. Therefore, the compensation for market risk
should, in our view, be lower.
They don't predict long term returns by estimating shareholder returns from businesses, such as by considering earnings (or dividends), growth, and the price paid. Nor do they use valuations like price to adjusted earnings, which has some theoretical justification for predicting future return. Instead they look at the past ERP and slightly reduce it because it should be lower with the investing tools available today.

William Bernstein on a similar belief:
The most popular misconception is that future stock returns somehow derive from past stock returns—that is, from the Stock-Returns Fairy.
http://www.efficientfrontier.com/ef/403/fairy.htm

stlutz
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Re: The Limits of Modern Portfolio Theory - Do Investors Understand What They Own?

Post by stlutz » Sun Apr 22, 2018 8:55 am

I would suggest that this concern may apply more to fixed-income securities. The Total Bond index is very simple investment to buy, but the bonds held therein can be complex instruments.

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dwickenh
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Re: The Limits of Modern Portfolio Theory - Do Investors Understand What They Own?

Post by dwickenh » Sun Apr 22, 2018 8:57 am

AlohaJoe wrote:
Sun Apr 22, 2018 1:47 am
It is an intriguing idea but I'm not convinced.

Did investors understand what they owned when they bought a mutual fund like Magellan?

Did investors understand what they owned when they paid into a pension fund?

Did investors understand what they owned when they bought a conglomerates like GE in the 60s?

Heck, do investors even really understand what they owned when they buy a bank or tech stock in 2018? Apple doesn't even report how much most of their products sell. Google doesn't tell you YouTube's revenue. And clearly no one understood banks or 2008 wouldn't have been as painful....
Good points AlohaJoe!!
The market is the most efficient mechanism anywhere in the world for transferring wealth from impatient people to patient people.” | — Warren Buffett

columbia
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Re: The Limits of Modern Portfolio Theory - Do Investors Understand What They Own?

Post by columbia » Sun Apr 22, 2018 9:09 am

I just looked over the holdings of the Vanguard small cap value and international small funds: I can guarantee you that I have no idea what those companies do. :)

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Re: The Limits of Modern Portfolio Theory - Do Investors Understand What They Own?

Post by neurosphere » Sun Apr 22, 2018 9:39 am

Noobvestor wrote:
Sun Apr 22, 2018 1:33 am
More and more, in addition to the index tracking the market, the market (or at least: its participants) tracks the index.
What’s more, the use of indexing has had unintended consequences on the behavior of asset owners and asset managers; it changes the focus of both away from “which businesses are good businesses worth owning?” to “how do we look relative to the index"
The quotes from the article imply (but do not seem to explicitly state) that companies valuations and performance are now driven more by factors of an index or some other such concept, rather than intrinsic factors and a company's specific strengths/weaknesses relative to its peers in the marketplace?

Consider this. When a corporation is making decisions on whether to sell stock or purchase stock, how do they decide? When a company exec is making a decision for his/her personal portfolio, how to they decide?

The point is that insiders, and those who feel they know more about a particular business that others, are likely still setting the price the same as always. In the long run, this sets a fair price. Has this changed? So what if some people are investing in broad indexes? What does that change?

So even though "investors" are thinking in terms of performance of an index, the companies which make up that index behave like they've always behaved. I think the article is simply another complicated way of asking the "what if everyone indexed?" question. And the correct answer is, of course, "purple". :D
If you have to ask "Is a Target Date fund right for me?", the answer is "Yes".

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grayfox
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Re: The Limits of Modern Portfolio Theory - Do Investors Understand What They Own?

Post by grayfox » Sun Apr 22, 2018 9:45 am

Paywall.

I found this other article: The Limits of Theory. Steven D. Bleiberg. April 2018

Does this present the same ideas?

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Re: The Limits of Modern Portfolio Theory - Do Investors Understand What They Own?

Post by bertilak » Sun Apr 22, 2018 9:53 am

I see indexes as a measure of stock returns, not a driver of them.

Companies still "make money the old-fashioned way: They earn it.” Ref John Houseman for Smith Barney circa 1979.
May neither drought nor rain nor blizzard disturb the joy juice in your gizzard. -- Squire Omar Barker, the Cowboy Poet

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neurosphere
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Re: The Limits of Modern Portfolio Theory - Do Investors Understand What They Own?

Post by neurosphere » Sun Apr 22, 2018 9:56 am

grayfox wrote:
Sun Apr 22, 2018 9:45 am
Paywall.

I found this other article: The Limits of Theory. Steven D. Bleiberg. April 2018

Does this present the same ideas?
From the introduction/summary of your link, which I bet shares the same general ideas as the barron's article:
And the idea that a market index is an optimal portfolio, rather than simply a broad measure of the market, has led people to believe
that it is a positive good to make no effort to judge whether a business is worth owning.
I'm not sure I have to read any further, as the author is either making a strawman argument, or completely misunderstands and is conflating multiple different concepts. His conclusion, of course, is that active management looks bad relative to indexing because managers are not "active" in the right way. If only managers would go back to valuing companies based on their individual overall characteristics, they'll do great. Or whatever.

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patrick013
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Re: The Limits of Modern Portfolio Theory - Do Investors Understand What They Own?

Post by patrick013 » Sun Apr 22, 2018 11:45 am

With the MPT you're going to end up on the efficient
frontier. Some investors seem limited by this while
others don't. 30% stock is lowest risk while 60%
stock lines up as the best trade-off between volatility
and returns. Higher percent of stock represents more
risk and higher volatility than the model might suggest.

Pragmatically and using diversified general indexes a 25%
stock portfolio would be considered conservative, 50% stock
would be balanced, and 75% stock would be an aggressive AA.
Same thing almost but different way of saying it. Beta, standard
deviations, and correlations would prove that out.
age in bonds, buy-and-hold, 10 year business cycle

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Re: The Limits of Modern Portfolio Theory - Do Investors Understand What They Own?

Post by jpdion » Sun Apr 22, 2018 12:01 pm

Confession: I do not know what I own in detail.

But, I do know what I own in concept, and am able to examine my portfolio AA using tools such as Morningstar's Portfolio X-Ray.

I know what I don't know, and can't pretend to think that I would ever have the ability to judge the relative values of individual equities and bonds, which are all subject to the daily (hourly?) dynamics of the modern market and political context. To take the Bogelhead path is to put faith in the statistical evidence that demonstrates passive, low cost broad index investing will, on average, over the long run, provide superior returns over actively managed mutual funds. It is faith because we all know that past performance is not a prediction of future returns.


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Re: The Limits of Modern Portfolio Theory - Do Investors Understand What They Own?

Post by pkcrafter » Sun Apr 22, 2018 4:24 pm

Another poor attempt at discrediting indexing. It doesn't even make much sense.

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

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Re: The Limits of Modern Portfolio Theory - Do Investors Understand What They Own?

Post by JoeRetire » Sun Apr 22, 2018 5:20 pm

Noobvestor wrote:
Sun Apr 22, 2018 1:33 am
Now, as a passive investor, I'm not going to go about asking what businesses are worth owning, just interested in others' thoughts.
Although some thought they knew, few folks actually knew what businesses were ever worth owning from an investment standpoint.

Should I own Pepsi if I prefer the taste of Coke? Should I own GM if I only drive Japanese cars? Should I own Enron because my uncle told me it's a great investment?

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Re: The Limits of Modern Portfolio Theory - Do Investors Understand What They Own?

Post by venkman » Sun Apr 22, 2018 11:06 pm

Noobvestor wrote:
Sun Apr 22, 2018 1:33 am
What’s more, the use of indexing has had unintended consequences on the behavior of asset owners and asset managers; it changes the focus of both away from “which businesses are good businesses worth owning?” to “how do we look relative to the index"
Now, as a passive investor, I'm not going to go about asking what businesses are worth owning, just interested in others' thoughts.

The question of which businesses are truly worth owning requires a level of knowledge and analysis that I (and I imagine most other people) don't possess and don't particularly care to put in the time to learn. More importantly, the question itself is irrelevant.

The important thing isn't whether or not Company A is worth owning. The important thing is whether Company A is worth owning MORESO than Company B, or Company C, or Company D, etc... Answering that question would require me to evaluate ALL the companies. And keep evaluating them an on ongoing basis. Even if I had the ability to do that, I don't have time or the inclination.

The other point is that I, as an investor, don't care about owning the "best" companies; I care about total return. To quote from a Larry Swedroe book, "The best businesses do not make the best investments." A horse with 100:1 odds only has to win one race out of 50 to break even with the horse at 2:1 odds. (Note: I'm pretty sure I'm conflating odds with regular fractions, so my math is wrong; but you get the point. :happy) All the "good businesses worth owning" will already have that fact reflected in their stock price.

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Re: The Limits of Modern Portfolio Theory - Do Investors Understand What They Own?

Post by Nowizard » Mon Apr 23, 2018 7:55 am

I suspect most people do not know what they own. They may know many statistics about a particular stock or fund, use portfolio theory, etc. but it is doubtful they have researched the individual stocks or funds in depth as opposed to using data from those who have. Probably not an issue for anyone other than those who enjoy endless stats and discussions if the manager of their fund (s) is considered trustworthy. Many of us are not able or interested in evaluating funds in depth when they can benefit from the expertise of others and occasionally inject a tidbit others may incorporate. Many of us are basically "limited" to portfolio theory.

Tim

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