A certain subset of investors have nothing but contempt for academic finance. The late Marty Whitman summed up the arguments against academic finance quite nicely (incidentally, a large number of his shareholder letters are available for free here and you should read them). In April 2003, he wrote:

For MCT [Modern Capital Theory], the proof of the existence of an efficient market centers on the observation that no individual investor, or institution, has ever outperformed a market, or a benchmark, consistently. Consistently is, of course, a dirty word: It means “All The Time.” Academics seem to be absolutely right in their observation that no one outperforms any market consistently. However, it seems asinine to offer this as evidence that fundamental analysis is useless or nearly useless. Lots of investors, especially value investors, outperform markets or benchmarks on average, or usually, even if no one from Warren Buffet on down can outperform a market or a benchmark consistently. Further, many, if not most, MCT acolytes seem sloppy in their observations in that a good deal of the time they conveniently ignore the “consistently” condition in describing the uselessness of fundamental research.

EMH seems to be absolutely valid in a special case. The basic problem with MCT believers is that they assume wrongly that this special case is a general law. EMH describes the investment scene accurately only when two conditions exist in tandem:

1. The solitary goal of a passive, non­-control investor is to maximize a risk­-adjusted total return consistently.

2. The security, or commodity, being analyzed can be best analyzed by reference to a limited number of computer programmable variables.

[…] MCT misdefines risk. For MCT, the word risk means only market risk, i.e., fluctuations in prices of securities. In fact, one can’t really use the word “risk” without putting an adjective in front of it. There is market risk, investment risk (i.e., something going wrong with the company), credit risk, commodity risk, failure to match maturities risk, terrorism risk, etc. At TAVF, we try to avoid investment risk. We pay less attention to market risk.

I think Marty was pretty fair in his critique. But here’s the thing. His two conditions are descriptive of most institutional and retail investors. Especially #1.

Most retail and institutional investors are preoccupied with risk-adjusted returns, and they define risk as market risk, a.k.a volatility. Most of the advisors who serve these investors are likewise operating under the same conditions, whether they want to admit it or not. The reason is they have to manage career risk, a.k.a “you are in the bottom quartile of your peers so now you are fired.” Career risk turns us into phonies.

Broadly speaking, two types of people spit venom at academic finance:

• People like Marty Whitman, who are successful investors and justifiably resent being lumped together with a bunch of phonies.
• Phonies working through their own self-loathing.

How do you know you are a phony?

If you have ever made an investment decision based on how a client will respond in a meeting, or how that investment decision might impact your ability to raise or maintain your assets under management, you have at least a little bit of phony in you. The more these considerations dominate your thought process, the more of a phony you are. The word phony has a negative connotation but it’s really nothing to be ashamed of. For most of us, it comes with the territory of managing other people’s money.

But the end result is that we end up managing highly diversified portfolios for people concerned with asset price volatility. For us, the assumptions underlying academic finance and portfolio theory in particular are valid.

What Portfolio Theory Is Good For

Portfolio theory is pretty good at explaining the performance of diversified stock portfolios. I say “pretty good” because investment performance is non-stationary (the parameters of the data change over time) and the assumptions we make about the underlying distribution of expected returns are overly simplified (investment returns are not actually normally distributed).

When you own a diversified stock portfolio, your performance basically boils down to:

• How much market exposure you have
• Whether your portfolio is tilted toward value or momentum
• Whether your portfolio is tilted toward big companies or small companies

Sometimes you will get a little residual boost from security selection, but it is tough to determine whether this represents luck or skill. Big mutual funds usually don’t like to break out multifactor attribution data because it is frequently unflattering and opens them up to (well-deserved) needling from quants who can provide the same exposures at lower cost.

Where Portfolio Theory Breaks Down

Portfolio theory breaks down if you are not diversified or if you change your definition of risk to something other than volatility, like permanent impairment of capital (which is how Buffett and Marty Whitman would define risk). Under these conditions, portfolio management is about maximizing expected value while managing down your risk of ruin.

Here you are not dealing with systematic exposures like value, size and momentum. Instead, you are exposed to the idiosyncratic risks associated with the specific securities you own (remember, you are not diversified enough for those risks to cancel each other out).

Reconciling The Conflict

Marty Whitman said it best: modern portfolio theory is valid for a particular set of conditions. When those conditions are violated it can seem comically silly. Yet, most professionals involved in money management are subject to the conditions that make portfolio theory valid. They are managing diversified portfolios for people who define risk as volatility.

So, like it or not, most of us are operating in a context where portfolio theory applies. Warren Buffetts and Marty Whitmans are few and far between.