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While this is about the epistemological foundations of Investment Theory, I think it might be of wider interest...

Most students of "Modern Investment theory" (as taught in most business schools) come away with the idea that above-average returns [known as "positive alpha"] are not possible to any investor (or, at very least, are not possible to most).

This is not about students being told that knowledge of investing is still in its infancy; that's not the point. Rather, they're taught that in principle, regardless of such knowledge, it is impossible to make above-average investment decisions. Indeed, if anything, further improvements in knowledge actually reduce the chances of making above-average decisions. In effect, the knowledge is futile in this particular field.

This post is not a critique of modern theory. Instead, I want to make the positive case for modern theory, to explain its plausibility. I also invite comment on the accuracy with which I portray it -- for I do not intend to build a strawman. At this point, I am not interested in explanations about what's wrong with the theory. I want to understand it before launching into criticism.

Context-setting: The context here is the buying and selling of tradable financial instruments, in a non-managerial fashion. Things like starting one's own business or owning art-work include other factors and are outside the scope of this discussion.

The "modern" position: The futility of making investment decisions is simple to explain with an example. Suppose there are two companies: A and B. For the sake of argument, suppose that Investment Science has reached a stage where we can make excellent estimates about how the shares of each company are going to perform.

Can we then use this knowledge and buy shares in the better company (say, Company-A)? I submit that we cannot. This is because enough investors would have gone to college and learnt the same Investment Science. They too will know that Company-A is better and will have reached similar conclusions as to the relative worth of the shares of these two companies.

In this situation, the prices of the shares of these companies will reflect the underlying estimates of their worth. So, if the shares of A are estimated to be worth twice the shares of B, then the price will reflect this. Therefore, with a given amount of cash, one would be able to buy a certain number of shares of A, or twice the number of shares of B.

Paradoxically, a person who knows nothing about investment theory could do just as well as the experts because the price at which the shares sell are always fairly close to the best-estimated value as calculated by the experts of Wall Street.

A common metaphor is that a "monkey throwing darts" at the stock-listing page of the Wall Street Journal can come up with a portfolio that will do "just average". Even if experts are a little better than average, we are told, one has to pay them for their services. Doing so, brings the net result back to average. We're also told that most Wall-Street funds do worse than average after one deducts the commissions of the experts. This has led to the advocacy of index funds. Importantly, while modern theory might lead one to index-funds, rejecting modern-theory does not mean that one must reject index-funds.

At this point, my questions are as follow:

  • Have I represented the modern position correctly?
  • Is there a better pro-Modern position to be made?
  • Can anyone think of a good analogy to MPT, in an unrelated field

Edited by softwareNerd
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the idea that above-average returns [known as "positive alpha"]are not possible to any investor (or, at very least, are not possible to most)

Assuming an even distribution of investment levels, it is true by definition that above average returns are not possible to a majority of investors.

I think the big flaw in the theory you present is that good investments are not made by analyzing the artificial public data pool created by the SEC. Good investors "invest in what they know." The egalitarian condemnation of "insider trading" masks the fact that the key to success is to take advantage of specialized market knowledge.

Profits are made not by chasing the markets, but by being the first to see opportunities. So for example, when I heard that Skype released a VOIP update that supports video-chat, I talked to my broker about investing in Logitech, which makes webcams. Statistical analysis alone could never lead you to that insight.

I’ve heard that most casual stock traders lose money on average because they “chase the market” – buying high and selling low. Their second-handed attempt to ride on other’s coattails backfires more often than not. Index fund investors fare slightly better by earning the average return. But the really successful traders are those with the skills to see opportunities that others miss.


At this point, I am not interested in explanations about what's wrong with the theory. I want to understand it before launching into criticism.

Sorry, I couldn't help myself :-p

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I hold a CFA charter and have been working in securities analysis and portfolio managment for 15 years. I have written functions in the R language that calculates CAPM and Fama-French betas for US stocks. So I'm very familiar with MPT and CAPM, and think that their epistemological foundations are worth scrutinizing.

I think the risk benefits of diversification are demonstrable, and diversification was around long before CAPM, so I think CAPM is the real issue to focus on, rather than lumping it together with other elements. For example, your link mentions both CAPM and the Fama-French 3-factor model, but the latter in key ways contradicts CAPM.

Your link offers a decent overview, but I've seen more detailed explorations that get into its epistemological foundations. Most notably, a presentation of CAPM usually starts with its premises.

My take on the CAPM:

Rationalist and anti-inductive, on principle.

It's a deductively created model that admits most of its premises are false.

It's conclusion, that market beta is the only relevant factor in expected returns, has been demonstrated to be false by market evidence. (You asked not to hear arguments against it, however, I mention it, because inductively arrived at theories don't usually have this problem).

The fact that indexes are hard to beat is not an argument in favor of the CAPM.

Furthermore - the portfolio optimization that the CAPM says we are all doing already (but we aren't), it actually extremely difficult to do properly, even by experts.

One of my most memorable experiences during my MBA at NYU was arguing in e-mails about the rationalism of CAPM to my finance professor, and then he showed his philosophical hand by citing Karl Popper and Kuhn as providing the epistemological base of modern finance theory. Even if evidence supported CAPM, I'd continue to look for an inductively-grounded alternative framework to replace it.

That said, I think market beta is an interesting calculation, with some potential uses, as are factor betas (which is why I took the trouble to program enhanced methods of beta calculation). But "Objective Investing" needs to move to an inductively arrived at, reality-based theory of investments, that considers the real nature of investors and the objects being valued, in a manner neither intrinsicist nor subjective.

Here's somthing related to this subject I wrote a few years ago.


I'll stop there for now, it's getting late.

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Can anyone think of a good analogy to MPT, in an unrelated field

As far as I know, there exists no "efficient racing" theory, but if you applied the same premises to car racing, you would conclude that all car races are decided by chance factors because all drivers will go as fast as possible. Such a theory would claim that the best racing strategy was to just imitate the moves of the car in front of you, as its driver has already taken all the characteristics of the racetrack etc. into account and incorporated them into his driving technique. When the conditions change, the driver in front of you will adjust to them immediately, so again it's best to just mimic him.

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The first near-analogy to CAPM I could think of came from Leibniz, also a rationalist, who deduced that God made sure we were living in the "Best of All Possible Worlds".


As in the CAPM world, Leibniz concludes that free will is an illusion, (as everyone at all times is paying the perfect price for all assets, and everyone holds an optimal portfolio at all times.)

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I am still chewing on this; but here are some thoughts thus far...

Profits are made not by chasing the markets, but by being the first to see opportunities. ...

...the really successful traders are those with the skills to see opportunities that others miss.

I agree, but a modern finance professor would not. His criticism would be something like this:

A few people, associated with a company, might see its opportunities early. Everyone else who is buying non-IPO stock has a counter-party who was in on it earlier than he and who is now selling. So, as in a used-car market, there is an "information asymmetry" that favors the seller. Thus, while one might well make out on some such deals, doing it over the long run will not work.

I agree that seeing oppotunities more-correctly and earlier than others is the key to stock-investing. It's broader than just a new product. Even completely public information is viewed differently by people. From Andrew's excellent CapMag article:

For example, a year ago, a large number of telecommunications firms had high debt balances and interest burdens relative to their revenues. Those who were writing reports and those who appeared to dominate the trading of these stocks tended to either ignore this fact altogether, or dismiss it as insignificant, given their expectations of high future growth.
Modern professors would say that Andrew was not "right" but just lucky. I think they view judgement of data as a non-material, almost non-existent factor.

The kernel of truth (if one might call it that) in the modern theory, is that it is not enough to be right about a company's prospects. As an investor, what also matters is being more right than other investors. By its nature, the relative accuracy of the investor's judgement is key.

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Why not? I would think that it's possible to know from evidence available to you (in greater or lesser degree) which horses are in better shape and have a better chance of winning.
Yes, but that is not good enough. Knowing the fundamentals is one step.

The odds on each horse reflects the judgements of other people. If a horse has a good chance of winning, the odds will not pay off that much. So, the second step is to know them better than other people who are making bets.

So, the key is that one has to be a better judge than the average betting person. While I don't know how one would do that in the case of horse-racing, I also do not see why it is impossible.

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First, I should have said that I was trying to answer the question by giving a theory analogous to MPT -- "efficient horse racing odds" is analogous to "efficient stock prices". Whether the theories are true is another question. My guess is that they are very close to being true, but not exactly.

So, the key is that one has to be a better judge than the average betting person.

Yes, but that average is weighted by the amount that the person bets. Someone who had a "system" that actually worked would probably keep increasing his bets (or investments) until he shifted the odds sufficiently that he no longer had an advantage, taking administrative costs (commissions, taxes, his time, etc.) into account. That is why the race track (or market) is (nearly) efficient.

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