The Greatest Investment Myth Exposed: Why Modern Portfolio Theory Will NEVER Make You Rich

November 12th, 2006

November 12, 2006 -

To determine if the person managing your $1,000,000 account is truly the expert you believe him or her to be, pick up the phone tomorrow and do this simple experiment. Do not give your financial consultant any advance notice to prepare any answers, but call him (or her) up and ask him what are the three best performing stocks in your portfolio. Then ask him what are some of your worst performing stocks. Then ask him what will be the best performing asset class for the next five years. And what will be the worst. And in what specific countries. And ask for detailed explanations for each answer that is given.

And get him to answer on the spot. Not in ten minutes. Or don’t let him tell you, “I’m in the middle of a meeting. Let me call you back and I’ll be happy to answer those questions.” Because if he was in a middle of a meeting, he wouldn’t have taken your call in the first place. That’s a stalling tactic. See if he can answer those questions on the spot, because any reputable advisor would be able to do so. And if your financial consultant has many clients, he should especially be able to answer these questions. How can he not know what are the best and worst performing stocks that 100 of his clients own? You might be shocked to discover how many financial consultants stumble over these most basic of questions and how many won’t be able to answer some at all. Think about what this implies.

Many financial consultants and or private wealth managers, even those with an impressive VP title, won’t be able to answer the above questions because the truth is they spend about twenty minutes deciding where to invest your money. What do I mean by this? They merely hand your money over to an internal or external money manager to manage your money, so in essence, they function like a middleman, connecting two people that need each other and taking a cut for their role in connecting you with the money manager. However, most money managers utilize Modern Portfolio Theory to peg your portfolio to the major index in their country, and thus diversify you into mediocrity every single year.

Think about this. If you were 85% confident that an investment in companies X, Y, Z in Sector A would yield 40% or greater returns within one year, why would you ever want to invest equally in Sectors A, B, C, D, E, F, G, H, I and J?

But this is what Modern Portfolio Theory of diversification will most likely do. In fact, most likely, managers that employ modern portfolio theory diversification to your portfolio will also diversify you into companies S, T, U, V, W, X, Y, and Z in Sector A as well because they employ a “no more than 3% of your entire portfolio in any single investment” rule.
Over the past half of a century, the investment industry has taught millions of people to accept certain investment mantras as truth, though there is very little evidence to support any of them. Millions of people accept the fact that the top global investment firms will act in their best interests, and thus hand over cumulative trillions of dollars to these “authoritative” institutions to manage their stock portfolios, no questions asked.

You must be willing to acknowledge that a much better platform of investing than Fundamental Analysis, Technical Analysis, and Modern Portfolio Theory exists, difficult as this may be to believe. It is no coincidence that in the first year I abandoned everything I had learned about investing as a long-time employee of U.S. Fortune 500 companies, that the performance of my portfolio skyrocketed from a lousy average of 6% to 8% a year to a more robust return of 40%.

On tap for tomorrow: J-REITs and REITs in Shanghai & Beijing

Morihei Ueshiba, the founder of Aikido stated, “martial arts must undergo constant change. Budo develops in an evolutionary manner together with the movements of heavenly bodies and must not stop even for an instant…Its form must be continuously renewed.” The same applies to anything in life. Relationships, friendships, technology, and yes, even investing. Nothing remains static. It is either progressing or devolving. Yet why have the large investment firm’s sales strategies regarding stock portfolios remained static for half a century? Modern portfolio theory, the grandfather behind diversification principles, was founded in the late 1950’s. Yet it has remained the predominant strategy of investment for large investment firms all over the world even today.

It has not changed one bit because investment firms have invested a substantial amount of time to convince the public masses that diversification is the only way to invest money responsibly when nothing could be further from the truth. Warren Buffet, at times, has had the bulk of his stock portfolio in just a handful of stocks.

Furthermore, as technology has evolved over the years, how can investment strategies not also have evolved? But this is what the giant investment houses would want you to believe. Again, remember the goal of investment houses is to gather assets. Your goal is to maximize your gains. Because these two goals do not converge, different strategies must be used to realize these two different goals. Modern portfolio theory is a great strategy for asset gathering. To maximize returns, it leaves much to be desired. And that’s an understatement.

Maholo,

Kaeho

On tap for me: How to Invest Like Buddha

Entry Filed under: Most Read Posts, The Biggest Investment Myths