Modern Portfolio Theory for Thee, Concentrated Economic Darwinism for Me. The Ultra Wealthy Employ Different Tactics for Equity Investing.

“Owning a Single Stock is Riskier than Holding a Basket of Securities, True or False?”

The survey challenge question blinked impatiently on my computer screen, waiting for an answer; commissioned by a leading economic advisory firm in conjunction with a media company and a global multiline investment bank, the survey compiles views on economic conditions and their potential impact on investment markets for the year ahead. Respondents are a cross section of economists, investment analysts, buy and sell side principals.

The initial, simple, challenge question has but one purpose; it is posed in order to weed out AI bots seeking to hoover up insights for their own data mining efforts. Answer “True” and additional, more detailed challenge questions pop up, before the body of the survey commences. Answer “False” and the survey cannot be completed.

Failure to complete the survey excludes one from reading the final output; those sitting atop the financial services and economics firms worldwide have a powerful incentive to participate in the annual census. Some utilize the compiled report as a form of confirmation bias, others rely upon it for internal forecasting and a number refer to it as a base for external modelling. Those unable to access the data are presumed to be at a competitive disadvantage; in the financial world, data is everything. Accordingly, an implicit form of coercion exists to participate in such surveys, by those who compete for investment capital. My situation was perplexing.

Diversification for the purpose of risk reduction (1 stock = bad, many stocks = good) is the main tenet of Modern Portfolio Theory (MPT), a mathematical investment modelling platform developed, occasionally referred to as mean-variance analysis, by economist Harry Markowitz. His paper, published in 1952, for which he was awarded a Nobel Prize, accelerated development of the modern day pension fund industry, laid the foundation for the creation of modern day investment indices, represents the marketing premise supporting the entire exchange traded fund business and is the omnipresent bulwark of compliance by leading global investment firms. To the investment industry, “owning a single stock is riskier than holding a basket of securities” is as reverential as the “In the beginning, God created the heavens and the earth” phrase contained in the Old Testament.

Modern portfolio theory legitimized the corporate conglomerate. Companies such as General Electric and numerous others, opted to diversify into dozens, hundreds, sometimes thousands of disparate and wholly unrelated businesses, many divisions competing AGAINST one another within the same company, all for the purpose of conforming to the edicts laid out by Markowitz. Warren Buffett, the legendary investor, held the output of Markowitz as sacrosanct and built his conglomerate, Berkshire Hathaway in response to global adoption of MPT.

For the past 68 years, the mass market equity investing industry has steadily and inexorably tightened around a thesis that one investment carries higher risk, for the security holder, than an equivalent dollar amount divided into multiple investments. Marketing of the theory is so entrenched that the investing public at large has bought into the truthiness of MPT. Ask any retail investor if they consider a single investment to be riskier than multiple securities (the investment industry prefers terms such as “basket” or “portfolio”) and universally, they will answer “yes”. Why do they answer this way? They do so because MPT, for almost seven decades, has been promoted to the investing public as indisputable fact.

In reality, the name “modern portfolio theory” implies elements of doubt; after all, if ownership of multiple securities was conclusively proven to be less risky than holding a single security, after many decades of testing and data, it should be called “modern portfolio law” by now. Nevertheless, Markowitz’s paper carries the seal of approval from the mainline investment industry at large. One of the largest and most important industries on the planet, the investment advisory industry, exists for the express purpose of building and allocating capital into holdings of multiple stocks to reduce risk. But, is it actually true; does owning one investment carry higher risk than holding a group of investments?

Consider the example of an investor who owns equity in a conglomerate. Is ownership of shares in one conglomerate, which has perhaps hundreds of divisions across multiple industries, is that riskier than owning a dozen or so separate companies? Conglomerates have multiplied specifically to offset risks indicated by MPT. Conglomerates were, and continue to be, a corporate alternative to mutual funds and ETFs; they are a collection of businesses held within one taxable entity. The answer is therefore, “no”; ownership of one conglomerate is not necessarily any riskier than holding a basket of separate companies.

Let us examine another example. Ownership of one single company might be less risky than holding a basket of securities based upon cap weight. A large company, in fact, the larger the better, might be sufficiently important to an economy that it becomes “too big to fail”; these strategically important titans will then be LESS risky than a dozen, or even a hundred of smaller cap firms, none of which are deemed to be vital to national interests.

Here’s a third example. Ownership of a single, non-cyclical company might be far less risky than holding an enormous basket of cyclical companies. Cyclical firms are tied to the strength or weakness of the economic cycle. Economic cycles feature periods of strength, of weakness and of stability. A solitary non-cyclical business, not tied to the strengths and weakness of the economy, may be readily considered a far less risky investment than an entire portfolio of cyclical equities.

A fourth example is qualitative. A single, well-managed company, regardless of its industry, might easily be posited as less risky than a multiplicity of badly managed companies.

A fifth example lies in jurisdiction. A single American company, protected by entrenched property rights and operating under strong rules of law, can easily be argued as being far less risky than 10, 100, or 1000 publicly traded companies on the Zimbabwe stock exchange, the Moscow Stock Exchange or the Venezuelan Stock exchange. The number of publicly traded companies one holds is irrelevant if those businesses exist in jurisdictions that are deemed politically risky to conduct normal operations.

These qualifiers; cap weight, qualitative management, cyclical vs non-cyclical, conglomerate vs non conglomerate and jurisdiction are far from tiny loose ends in an otherwise bulletproof theory; they represent massive, gaping sinkholes capable of subsuming an entire thesis. In fact, so many additional contradictions exist to poke holes in the basic premise of MPT that there seems little doubt as to why it remains a theory, instead of being codified into law.

Markowitz probably never gave a passing thought to Charles Darwin. Darwin’s premise of natural selection theorizes that all species of organisms arise and develop through the natural selection of small, inherited variations that increase the individual’s ability to compete, survive, and reproduce. And, unlike Markowitz’s theory, whereby one amateurish blog piece has itemized enough holes that the Nobel Prize Committee would be justified in asking for a return of their medal, a lot of scientists have endeavored to poke holes in natural selection; some have been able to nibble away at the margins but have yet to offer a more compelling alternative theory. The key point of Darwinism is that an entire species is at risk of extinction when a more competitive species evolves. Any initial numeric advantage means little once natural selection takes hold. Darwinism is widely understood; to quote American president-elect Joe Biden: “you know the thing.”

Moving to the business world; a concept of “economic Darwinism”, where only the fittest organization will prosper in a competitive environment and has the potential to ultimately drive less evolved firms to extinction, has also been postulated. Appraised against the yardstick of net worth amassed in equity investing, it would seem that modern portfolio theory has been upended by the theory of economic Darwinism. Of the top ten wealthiest persons on the planet, using net worth estimates from holdings in publicly traded securities, 9 out of 10 have just one or two holdings that account for the overwhelming percentage of their net worth. Bill Gates, Mark Zuckerberg, Jeff Bezos, Elon Musk, Bernard Arnault, Mukesh Ambani, Amancio Ortega, Larry Ellison, Sergey Brin, Steve Ballmer, Jim Walton, each amassed their incredible fortunes primarily via ownership of one equity. None significantly diversified their holdings throughout their lives; they started out holding one stock, maintained ownership through thick and thin (more thick than thin) and to this day, continue to hold that one stock. In each case, that single successful investment accounts for the lion’s share of each person’s wealth. Only 1 person in the top 10, Warren Buffett, indirectly holds a diversified portfolio, via his investment in Berkshire Hathaway, a conglomerate.

Statistically, when a model is only accurate in the prediction of an outcome 10% of the time, it is considered to be a failure. Based upon the investments reported by the top 10 wealthiest individuals worldwide, where 90% of their equity wealth has accrued from steadfastly ignoring the recommendations of modern portfolio theorists, one can go so far as to suggest that the 1 person in 10 in the ranking achieved their financial success in spite of modern portfolio theory diversification; a 10% accuracy rating falls into the realm of statistical chance (luck). Consider the statistical outlier in the top ten wealth rankings, Warren Buffett. The math suggests deliberate diversification actually hindered the growth of Warren Buffet’s wealth. He used dividends earned from superior, high EBITDA, industry leading investments such as Coca-Cola to purchase less successful investments. In fact, some data clearly suggests that had Berkshire Hathaway maintained the holdings of the highest returning early successes, reinvested the dividends back into those underlying businesses and held them patiently, rather than divert the dividends towards investment into lower returning businesses, Warren Buffets net worth might be almost 5 times higher than it currently sits.

At the equity level, economic Darwinism accelerates capital concentrations, for the benefit of the evolved business within an industry, while simultaneously pulling capital from firms unable to compete. This can produce some some shocking equity price increases, from time to time, for the evolutionary business. Economic Darwinists consider these moves to be permanent. MPT advocates, in contrast, deem them to be temporary. The inability of MPT to precisely account for the capital redeployment, away from weaker companies and to the new company, whenever an evolutionary business appears, is a great failing of modern portfolio theory in the 21st century. MPT treats ANY major share price advance as a transitory event; disciples of MPT conclude that if one just waits long enough, a regression to the mean (share price decline) will inevitably ensue. MPT does not allow for the possibility that a swift equity capitalization transfer, utterly destroying the value of other businesses, occasionally imploding an entire sector or industry, with one company absorbing an outsized amount of capital under its own roof; that such a shift might be permanent. Time after time after time, MPT misinterprets sustained equity advances and deems them to be at imminent risk of reversion. When proven to be wrong, the fallback for a modern portfolio theory disciple remains: “just you wait, its gonna happen, give it more time.”

Without question, the failures of MPT have been observed and duly noted by the wealthiest persons on the planet; also not lost on the wealthy is the point that this isn’t a recent failure, it is a persistent failure. We all marvel at the net worth of Jeff Bezos via his holdings in Amazon. If we calculate the aggregate market value of all of the retailers in competition with Amazon, at their peak, deduct what they have since lost in value, entirely due to the emergence of Amazon; one can determine that at least half of Bezos’ net worth has accrued via capital destruction of competing businesses and the shift of those equity values into Amazon. Holding ONLY Amazon has turned out to be a less risky investment than holding ALL other publicly traded retailers in the world. Mr. Bezos certainly didn’t sell down his holdings every time that Amazon rose by an arbitrary percentage. No doubt, he received a few calls over his early career from intrepid Wall Street heads, advising him to “diversify”; Bezos likely told them, in no uncertain terms, to sod off.

Economic Darwinism certainly applies for Alphabet and Facebook, which have collectively destroyed the newspaper, magazine and most advertising reliant media while transferring those market capitalizations into their own corporate structures. Again, was the investor holding only Facebook assuming more risk than holding, say, a publishing and advertising ETF comprised of 100 companies? The answer is no. Economic evolution also goes a long way towards explaining the success of companies such as Apple, Microsoft, Tesla, Netflix, MasterCard, Visa, PayPal, among others.

When a single, evolutionary business emerges the risk/reward calculation is thrown askew. Competitors to that evolutionary disruptor now have an element of added risk, from partial business impairment to total destruction. In such events, diversification is pointless, resistance seems futile; modern portfolio theory has yet to prevail in any instance, when confronted by evolution. So many disclaimers and qualifiers are affixed to MPT; it doesn’t always reduce risk, it relies upon coercion to push investors into selling down great investments and resultingly, diminishes returns to the point that the process seems a wash. The ONLY clear beneficiaries of diversification are those investors sufficiently lousy at picking investments that diversification serves to ameliorate losses.

Why then, does the investment industry continue to market modern portfolio theory diversification as the optimal public solution? The obvious answer is industry profit. Since the deregulation of fixed commission schedules for security transactions, investment firms have embarked upon a systematic program to convert long term investors into short term traders. Aggressive marketing by discount investment firms, which promote commission trades capped at miniscule dollar amounts, have accelerated this trend. Consider an investor with a million dollars of capital; a purchase of a single stock with that million would generate just $9.95 US in total commissions at a discount firm. That one equity might generate 4 dividend payments annually, which, if used to purchase more shares of the same firm (and assuming that no automatic dividend reinvestment is offered), then a further 4 trades might occur which cost another $39.80 of commissions annually. On the other hand, if the discount firm’s compliance and marketing department promoted the diversification of the $1 million in capital towards an assemblage of 100 securities, for the “safety” of the client, in accordance with MPT, then that same million dollars would generate about $1,000 US in initial commission. After the portfolio of 100 securities is purchased, perhaps 400 dividends annually are earned, annual reinvestment commissions likely match or exceed the initial investment commissions (not all stocks participate in automatic reinvestment).

Next, the discount firm offers a bunch of cool “free” tools, titled as portfolio monitoring; they train clients to execute multiple transactions regularly such as stop buys, stop loss, limit orders, etc. The more securities held within the account, the more likely it becomes that transactions will occur. Equities trading is assiduously marketed and incorporates the same tactics used to convert entire populations with healthy lungs into nations of smokers: “trading is cool, don’t you want to be cool?” Long term investing is frowned upon; long term investing with concentrated accounts is even more actively discouraged. “A million dollars into one stock, are you nuts?” states the business person, who doesn’t think twice about placing a million dollars into one residential house, one private business holding, one commercial property, or one piece of raw investment land. An emphasis on MPT diversification by investment firms for the past 70 years is, in my assessment, indoctrination by repetition.

The second reason for an emphasis on MPT, I believe, is more insidious. The easiest way for the 1% to stay on their perch and look down at the masses is prevent the masses from emulating proven success. Too many neighbors atop a mountain peak spoil the view. Therefore, the rich say one thing, but do another (rules for thee but not for me, one investment process for thee, but not for me). They quietly adhere to one system for investing, while publicly nodding with assent to an investment industry that promotes an inferior system, one that takes more time, seldom reduces risk, diminishes returns on capital and increases taxation sharply. Global marketing of an investment model centered upon holding a great number of investments, most of them ordinary, selling down winners so that they do not become an outsized percentage of your portfolio and regularly trading (which triggers taxation) represents a form of coordination between the ultra wealthy and the investment industry, a sort of symbiotic partnership that serves to keep the masses right where they are now. Promotion of a detour, far from the real shortcut to the top, via putting up bright neon signs along the longer and bumpier road, has worked to keep the peak pretty clear.

“Sell down your winners and maintain appropriate portfolio allocation”? Yes, by all means, purchase a 1966 Shelby 427, in 1966, at the dealership price of $8,000. When the value of that Cobra doubles, sell off enough parts to recoup your original $8,000 investment. The Cobra doubles in price again, so you sell off another $8,000 in parts. Do this several more times, until you have earned $80,000 off of that original $8,000 investment; and best of all, you tell yourself, you still hold a Shelby Cobra. What actually remains in the garage is just a chassis and some bits of sheet metal. Being unimportant to your overall net worth, the car stops being of interest, so eventually, you sell the chassis and metal for $20,000.

Years later, a friend tells you that an intact 1966 Shelby Cobra 427 has just sold for $5.5 million and by the way, don’t you own one? “I did”, goes the reply… “sold it and made out like a bandit!” In total, parting out a Cobra earned you $92,000 in profit on an $8,000 investment, but you DID NOT earn the $5,492,000, had you just left the car intact. Your foregone profit was 60X the realized profit. Trading, disguised as risk mitigation, resulted in a profit that was was just 1.7% of the optimal return.

“A great series of trades” declares the MPT advocate. ‘You parted out a vintage Shelby Cobra?” counters a wealthy collector, dumbfounded. “I am SO sorry to hear of your troubles, are you Ok? Have you…uumm,…have you talked it through with someone close to you?”

Parting out a successful, occasionally irreplaceable, investment seems to be ludicrous, mindless, profit limiting advice; yet that is precisely what the mass investment industry advocates to retail equity investors, all to comport with a mathematical model that, since 1966, had annually determined a Shelby Cobra to be overvalued against a 1966 Ford Mustang and a 1966 Chevrolet Camaro. For 54 consecutive years, that Carroll Shelby Cobra overvaluation has failed to revert to the mean, but just you wait, its gonna happen, give it more time.

Overvaluation, undervaluation, fair-market valuation: these all represent terms drummed up in order to promote trading opportunities. An MPT advocate declares Microsoft to be “overvalued” one day. That statement is entirely based upon a comparison of the prevailing share price of Microsoft against a basket of other technology businesses, or against a basket of other securities that have been assigned as some sort of proxy, or against…..something. What MPT market timers fail to inform is that NONE of those other comparative values represent perfect substitutes to Microsoft. In equities, if one owns an evolutionary business, then the number of completely equivalent investment alternatives to Microsoft, or Amazon might be ZERO. Lacking an actual basket, or perfectly comparable businesses, all that an MPT proponent offers is a guess. Are they making that guess because they don’t like the business of Microsoft? Is it that they hope for Microsoft to decline in value in order to potentially acquire it at some later date? Let’s get one thing straight; if you own an equity, you do so because you think that it is undervalued at best, fairly valued at worst. If, on the other hand, you declare it to be overvalued, then you likely don’t hold a single share in that investment or have some shares and hope for external validation regarding your already-determined decision to sell. MPT valuation models only have some potential validity within freely competitive industries. If a business is monopolistic or represents an evolutionary disruptor, lacking exactly comparative alternatives, any discussion of an alternative basket is based upon flawed logic; accordingly, traders and market timers cannot confidently provide ANY assertion on valuation.

The ultra-wealthy cannot be bothered with ill-thought counsel, trading programs tied to valuation bias or profit limiting transactions disguised as risk management, all determined by a mathematical model that fails to differentiate between a Ford Mustang Cobra and a Carroll Shelby Cobra. “Sod off” probably increased in popularity as a saying by the ultra-wealthy once Wall Street started test marketing the notion of diversification. As a result, Wall Street stopped bothering the really rich and promulgated the theory of diversification upon the mass affluent. Annual wealth rankings bear it out. Hedge fund Barons aside, an overwhelming number of the top 10, the top 100, the top 1000 wealthiest persons worldwide rely upon concentrated investment portfolios based upon some variation of economic Darwinism, rather than MPT diversification, to amass their wealth.

Economic Darwinism is based upon the premise that risk isn’t specific to the number of investments one owns (diversification) or how much you allocate into one stock (concentration); the real risk lies in holding inferior business specimens and selling off evolutionary winners prematurely. Selection and duration are the key ingredients to success for the ultra-wealthy; diversification for its own sake is not only unnecessary to ascending wealth rankings, it seems downright counterproductive.

Mass market investment firms, when presented with annual wealth reports, retort: “well, these persons are taking great risks to get where they are, you do not really want to put a substantial amount of capital into that equity”, or “these are executives or founders of the companies, you cannot seriously expect to hold stocks as long as they do.” Both responses fail to stand up. Why can’t we hold a stock as long as a key shareholder? Nobody is putting a gun to our heads to trade stocks, we do it to ourselves. ARE the founders or key executives taking great risk? They SHOULD know more about their businesses than some external analysts or pundits; after all, these people are stinking rich, so maybe we should give them the benefit of the doubt. If we own their same stocks, for their same duration, and don’t do stupid things like trying to trade around the positions for a few percentage points, then we’ll earn the same percentage returns as they are earning.

Capitalism isn’t static; it evolves. Why would a 68 year old model, one that cannot stand up to cursory scrutiny, remain the foundation supporting 21st century investing for the mass market? Based upon the portfolio compositions reported by the wealthiest on the planet, the ultra-rich have evolved away from modern portfolio theory; one or two notable outliers aside, most never applied it at all. If the super-wealthy of the world don’t trade stocks frantically, if the super-wealthy don’t care a whit about diversification and if super-wealthy of the world, presumably, aren’t suckers, well then, just who are the suckers? Certainly, the wealthy are not informing you that they are on board with concentrated evolutionary Darwinism for their investment capital; but holding reports certainly confirm such notions.

We, the great unwashed, DO possess a modest information equalizer of our own. The wealthiest people in the world are quite proud of their investments, to the point that many publish their equity holdings with regulatory agencies, some completely on a voluntary basis. Exactly what prevents us from emulating their concentrated positions and holding duration? From a practical standpoint, there are no impediments; the pushback comes from a seven decade global marketing program urging against the adoption of a simple, cost effective, pragmatic approach in favor of the complex, more expensive program.

“Owning a Single Stock is Riskier than Holding a Basket of Securities, True or False?” My coffee had become cold during the time I spent ruminating on the question; the computer had gone into sleep mode. After hitting refresh, the question glared at me coldly, as if it was preparing to say “submit to the will of the global investment marketing machine and let’s get on with it”. Yet, despite having answered “yes” to that same question, for the last two decades, this year, I could no longer bend the knee. The wealth gap between those that hold concentrated portfolios and adhere to the practice of economic Darwinism vs the masses, who are being promoted a seven decade old investment theory (why, after 68 years, is it still called “modern portfolio theory, should it not be “vintage portfolio theory?”) continues to grow. To me, that challenge question represented a false choice, MPT is just a theory. Acceptable answers for challenge questions often exist well beyond the standard “yes” or “no”; in this case, the logical answer is “it depends”.

After finishing the last gulp of my now room temperature dark roast, for the first time in twenty years, I opted out of the annual survey. For all intents and purposes, in the eyes of one of the most influential print media organizations on the globe and to the investment God that is MPT, I am now an apostate; that’s fair, because I no longer believe in parting out Shelby Cobras, I prefer the theory of evolution. Math is important; context and nuance need not be subordinate. What most professional investors call “mean variance analysis”, I now refer to as “profit limitation analysis”. Yet, my conscience remains clear, I have not yet been branded with the mark of a heretic, colleagues don’t charge towards me at symposiums, scythes in hand, bellowing “J’accuse!”. Demonstrated results from an overwhelming percentage of the wealthiest persons on the planet indicate that at least one alternative path to MPT exists, a more evolved and straightforward way, to aid in the objective of building wealth with equities.

Evolutionary concentration, without actively trading, is how the most of uber-rich of the world approach investing; if it is good enough for 90% of the ten wealthiest persons on the planet, it should certainly be good enough for me. As the shortest distance between two points is a straight line (no Einstein Rosen bridge straddles this road), I choose to ascend the mountain by taking the straightest line. A lack of signage on the road is inconsequential; I simply follow the visible tracks left by wealthy people and their money lugging Sherpas, ahead of me.

“Owning a single evolutionary stock is riskier than holding a basket of competing stocks threatened with extinction, True or False?”

Posted in Open Blog

Leave a Reply

Recent Comments