I was engaged in a discussion with some critics of mine the other day and some words came out of me that had never come out of me before.
The Validity Of Modern Portfolio Theory
Buy-and-Hold is rooted in Modern Portfolio Theory. My critics were making some arguments that made clear that they believed that Modern Portfolio Theory is valid beyond question. I certainly do not believe that. So I did a Google search on the question: “Is Modern Portfolio Theory outdated?” One of the articles that came up as a result of the search pointed out that the theory is rooted in two questionable premises: (1) that investors are rational; and (2) that investors have access to the information they need to make sound choices.
Those two premises seem highly dubious to me. I know with certainty that investors do not have easy access to the information they need. I know this because my examinations of the implications of Shiller’s research are banned at numerous investing sites even though many investors have praised them effusively when they have been able to gain access to them. Buy-and-Holders do not want people to hear challenges to their strategy. And Buy-and-Hold is the dominant strategy today. So Buy-and-Holders have been able to silence challenges to the strategy just about everywhere and everytime that they appear. Most investors have heard the case for Buy-and-Hold but not the case against it. They do not have access to the information they need to make sound choices.
Are investors rational? Robert Shiller obviously does not think so. He titled his book “Irrational Exuberance.” It follows that he does not believe that the Modern Portfolio Theory is valid (although I have never heard him make this precise claim).
How Stock Investing Works
There is no reason why anyone should believe that Modern Portfolio Theory produces a good understanding of how stock investing works. But millions of people do. What’s going on?
It hit me while I was engaged in that recent discussion with some critics of mine at my blog. To make the case that investors are not rational, I noted that there are thousands of novels that make the case for human irrationality in a compelling way. That convinces me. And I think it would be fair to say that it convinces Shiller, at least to a considerable extent. Shiller has said that it was talking things over with his wife, who works in the psychology field, that caused him to do the research that ultimately caused him to be awarded a Nobel prize.
A model that assumes rationality among beings who are often not rational at all is not going to suggest sound strategies. But as soon as I wrote the words on the computer screen about novels, I knew what the reaction among my Buy-and-Hold friends would be. For 18 years now, I have been arguing that it is not possible to perform a solid investment analysis without taking valuations (emotions!) into consideration. The response of my Buy-and-Hold friends has often been to observe that I am not a top-flight “Numbers Guy.” I am not! I have never claimed to be. I did better on the writing side of the SAT than I did on the math side. I am good at understanding psychology. I am good at understanding novels. Does that count for anything?
Humans Are Not Rational
Not according to Modern Portfolio Theory! Psychology and novels teach us that humans are not rational and Modern Portfolio Theory is rooted in an assumption that they are. It upsets Buy-and-Holders for these ideas to even be discussed. It’s cheating! It’s as if we were playing a game in which one of the rules is that the effect of human irrationality can never be considered and then this Shiller fellow showed up on the scene and showed that the consideration of irrationality is critical. If the effect of irrationality is not considered, the number on your portfolio statement is the true value of your stock holdings. If the effect of irrationality is considered, that number needs to be divided by two when the CAPE value resides where it resides today. The irrationality effect can be a big deal!
It all goes back to the Enlightenment. It was during the Enlightenment that humans became excited by the idea that they could put their reasoning powers to use making human life a richer experience than it had ever been before. I love the Enlightenment. I am grateful for the many ways that it has enhanced my enjoyment of life. I am all for rationality.
But I believe that the psychologists and the novelists have made contributions along those lines too. Psychologists and novelists use the power of reason to present an understanding of human life that is more realistic than the one that comes from believing that we humans are really Vulcans. We just do not behave that way. Which means that a model for understanding how stock investing works cannot get it right for so long as it assumes that we do. Part of a truly enlightened approach would be recognizing that those darn humans sometimes behave in wildly irrational ways and that an analysis of stock investing that does not take that reality into account cannot possibly get things right.
Rob’s bio is here.
Original Article Posted at : https://www.valuewalk.com/2020/06/modern-portfolio-theory-buy-and-hold/<\p>