Warren Buffett Modern Portfolio Theory

The essay sample on Warren Buffett Modern Portfolio Theory dwells on its problems, providing a shortened but comprehensive overview of basic facts and arguments related to it. To read the essay, scroll down.

Warren Buffett, alongside Benjamin Graham is considered to be the leading gurus of investment strategy. Though Benjamin Graham pioneered the notion of ‘value investing’, it was Buffett who consolidated the theory through repeated application. The consistency with which Buffett’s portfolio out-performed the average market results does prove beyond doubt the veracity of his ideas.

His investment management company Berkshire Hathaway had consistently outperformed both the broader markets as well as competing investment funds. Yet, some of his ideas come across as counter-intuitive at first. For example, Buffett’s assertion that he buys stocks with no intent of selling them stands against the common practice of booking profits when the price is high. This essay will further elaborate how Buffett’s strategies differ from other contenting investment management theories.

Warren Buffett’s strong faith in a few fundamental ideas of investing puts him at odds with several other financial experts. More specifically, Buffett’s ideas are at odds with the principles entailed by the Capital Asset Pricing Model (CAPM) and its versions. Since the CAPM is based on the older Modern Portfolio Theory, it is important to learn the underlying assumptions behind both these theories. These two theories and their variants basically assume that investors try to minimize risk to the extent possible. Moreover, CAPM “assumes that investors have rational expectations concerning expected returns.

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Under this assumption, CAPM says that the expected return on an investment is equal to the risk-free rate of return plus compensation for the systematic risk of the investment in the usual sense…The systematic risk is measured by the degree of variability of the individual investment versus the market as a whole. It relates the risk premium associated with a particular stock (its return less the risk-free return) to that associated with the market as a whole.” (Sullivan, 1997)

Essay Warren Buffett

Buffett found several weaknesses with both the MPT and the CAPM. Firstly, why should one give such importance to risk instead of focusing on security analysis as proposed by Benjamin Graham, wherein the investor would study the strengths and weaknesses of each company by looking at its financial strength, earnings prospects, debt levels, marketing strategies or many other measures that management use? (Schroeder, 2009) Further, there are other flaws in the modern portfolio theories as well. For example,

“investors are very concerned by downside volatility, but how many object when their portfolio moves up? Volatility is a measure that regards upside movement as equally bad as movement to the downside. What about inflation and the terrible toll it extracts on non-growth assets? Finally, speculative stocks which are extremely volatile do not fit into this mould as they certainly do not give superior returns, as a diversified group or otherwise. Right from the start this definition of risk seemed unrealistic. There are many problems with the whole concept. For starters there actually isn’t any permanent correlation between risk (when defined as volatility) and return. High volatility does not give better results, nor does lower volatility give lesser results”. (Schroeder, 2009)

Hence Warren Buffett’s criticism and scepticism over MPT and CAPM is based on sound reasoning. Another principle that Buffett strongly believed in is ‘less diversification’. Buffett believed that diversification is an insurance against ignorance, for which he got criticized by other leading investment gurus. But there is sound logic and rationale behind Buffett’s assertion. For example, as long as one studies the company, industry and the prevailing economic conditions one will be able to assess the future earnings prospects for the company. And since these parameters will vary between stocks and industries, the opportunity presents itself to pick the most under-priced of the securities. While modern portfolio managers would recommend a spread of 30 individual stocks, the portfolios of Berkshire Hathaway would show decidedly less diversification. Yet, Berkshire Hathaway has consistently outperformed competing investment management firms on a year-on-year basis. Hence there is indeed merit behind many of Buffett’s investment strategies, although they might at first seem counter-intuitive and risky (Sullivan, 1997).

At the beginning of the twenty-first century both Warren Buffett and Bill Gates were identified to be the richest individuals in the world. Yet, the two individuals could not be more different from each other. Bill Gates, the founder of Microsoft Corporation, is an Information Technology entrepreneur, whose creative imagination and hard work made Microsoft the leading software company in the world, with its products being used widely. Warren Buffett’s genius, on the other hand, is not so much in imagination and entrepreneurship, as it is in patience and adherence to principles. Buffett had once stated that ‘laziness’ is a virtue as far as long-term investment strategies go. And one can see the application of this in is own investment strategies, where he rarely shuffles his portfolio around. This principle goes against modern portfolio management theory as well, where its practitioners believe in ‘actively’ managing the set of stocks in their portfolio. But the superiority of Warren Buffett’s principle is proven by the impressive return on investment that Berkshire Hathaway has given its investors (Nace, 2008).

The relevance of contrasting modern portfolio management theories to that of Buffett’s old-fashioned adherence to ‘value investment’ principles need elaboration. To take an example, when the entire investment community was riding the dotcom boom, Buffett strictly avoided the entire sector. This was due to his belief in the idea of ‘circle of competence’. Warren Buffett had modestly admitted in interviews that he doesn’t fully comprehend the business model of a dotcom company and hence the entire sector is outside of his circle of competence. In the long and illustrious career of Warren Buffett and his firm Berkshire Hathaway, this modesty proved to be a crowning jewel. As the rest of the global economy crumbled due to the bursting of the dotcom bubble, Berkshire Hathaway’s chosen set of stocks were able to absorb the shock due to their insulation from the unknown domain of Information Technology (Nace, 2008). Coming back to the reverence to Bill Gates, it is a remarkable fact that Warren Buffett had never held the stock of Microsoft Corporation in his portfolio. To the contrary, Buffett had always felt most comfortable with the business model of insurance companies, and hence picked companies from this sector while totally avoiding Information Technology stocks. Old fashioned as it might sound, the robust results shown by Berkshire Hathaway is for all to see. This also reiterates Buffett’s rationale behind ‘less diversification’. Contrary to modern portfolio theories, Buffett actually saw diversification as increasing the potential for loss. (The Essays of Warren Buffett, 2009)

References:

Buffett, Warren; Cunningham, Lawrence. The Essays of Warren Buffett: Lessons for Corporate America, Second Edition. The Cunningham Group. ISBN 978-0-9664461-2-8.
Schroeder, Alice (2009). The Snowball: Warren Buffett and the Business of Life. Random House. pp. 656–657. ISBN 978-0553384611. Excerpt available at Google Books.
Ted Nace, “The Education of Warren Buffett: Why did the guru cancel six coal plants?”, Gristmill, April 15, 2008
Warren Buffett’s Letters to Shareholders”. Berkshire Hathaway. Archived from the original on 2007-03-22. http://web.archive.org/web/20070322071600/http://www.berkshirehathaway.com/letters. Retrieved 2008-05-20.
Sullivan, Aline (1997-12-20). “Buffett, the Sage of Omaha, Makes Value Strategy Seem Simple: Secrets of a High Plains Investor”. International Herald Tribune. http://www.iht.com/articles/1997/12/20/mbuff.t.php.