Various Financial Theories, Debunked

Special Report

Various Financial Theories, Debunked

December 31, 2023

Efficient Market Hypothesis; CAPM; Modern Portfolio Theory; Efficient Frontier

(From the December 29th 2023 Weekly Summary, slightly edited)

“There is no greater obstacle to learning than to be the prisoner of totally invalid but dogmatic theories.”

Peter F. Drucker (November 19, 1909 – November 11, 2005) was an Austrian-American management consultant, educator, and author, whose writings contributed to the philosophical and practical foundations of modern management theory.  He was also a leader in the development of management education, and invented the concepts known as management by objectives and self-control, and he has been described as "the founder of modern management".

Mr. Drucker is absolutely correct.

As an MBA graduate (’93, Dean’s Honor List, and tied for 2nd overall out of 280 students in the 2nd and final year) of what was then and probably still is the best MBA Program in Canada (the University of Western Ontario, at the time equal to Harvard), I can state that we were taught some perfectly logical and brilliant financial theories, coined by giants, that have, over the decades, turned out to be nothing more than ivory-tower exercises to try to explain the irrational nature of the financial world and fit it into a neat little series of boxes with red ribbons tied around them.

And that is why they fail: there are no “one-size-fits-all” financial theories that encapsulate the span of human behaviour or understanding or market dynamics, and thus there are exceptions can be exploited, which is what we do at Cynergy Research, and why our Global Growth Model Portfolio Total Returns have beaten the TSX Total Return Index by a wide margin over the years (currently a CAGR difference of 4.5% per year for 6 years, and 4.3% per year in the case of the Clements' Family Portfolio over 13 years).  Behavioural Economists would likely agree with the foregoing statements and the ones that follow.

And yet the irony is that every year there are hundreds of thousands of MBA graduates all around the world, almost all of whom are taught these nonsensical, perfectly-formed and impressive Nobel-Prize-level Theories, and then they go to work at banks, brokerage firms, pension funds, mutual funds, and so on, where they do all kinds of damage.  And a few even move on to become financial newsletter publishers…egad.

The specific flawed theories that are perpetuated on the unsuspecting are, in no particular order:

1. The Efficient Market Hypothesis, which simply holds that all market participants have access equally to all known information, and therefore all stocks are “perfectly-priced”, and it is thus impossible to “beat the Market” because stock prices instantly respond to new information as it comes available.  This is simply untrue re the foregoing elements in total, and the best rebuttal is from Warren Buffett, who wrote “The Superinvestors of Graham-and-Doddsville”.  And on a personal level I take advantage of minor to major share mis-pricings about once a week on average, which provides me with Alpha on the personal and family portfolios.  The common theme amongst these mis-pricings is Panic or Greed, by the way, aided and abetted on occasion by bank and hedge fund Automated Trading Algorithms that can push prices to an extreme.

2. The Capital Asset Pricing Model, which is an extremely elegant method of valuing companies but which has one fatal flaw: it equates Volatility to Risk with regard to Beta (the amount that a stock price moves relative to the Market average) the latter of which is a core component of CAPM.  Our definition of Risk is completely different: it is the permanent impairment or permanent loss of Capital (in the graph below, as you move along the Risk axis at the bottom, the range of possible outcomes increases, and finally includes the possibility of Total Capital Loss – courtesy of Howard Marks, page 43, "The Most Important Thing Illuminated").  When you take this approach to defining Risk, CAPM gets tossed out the window.  For a rebuttal to CAPM, see this series by top investors, including Graham, Buffett, and Klarman.  And as Howard Marks says, “the traditional risk/return graph is deceptive because it communicates the positive connection between risk and return but fails to suggest the uncertainty involved.  It has brought a lot of people a lot of misery through its unwavering intimation that taking more risk leads to making more money.” (The following) “…version of the graph is more helpful.  It’s meant to suggest both the positive relationship between risk and expected return and the fact that uncertainty about the return and possibility of loss increase as the risk increases.” 

Frankly, below is one of the most important Graphs that anyone will ever see in their lifetimes, but most people will only "get it" after they've been burned multiple times, each time hoping for a different outcome.  A related fallacy is to think that if you make 10 independent gambles, one of them is bound to pay off.  This can lead to ruin as each gamble is an independent act, and you can have 10 independent total failures, thus losing all your hard-earned Capital.

3. Modern Portfolio Theory, which is basically just an extremely complex method of attaining average returns with lower Volatility.  If you want average returns, buy an ETF based on the S&P 500 or the TSX Index and it’ll cost you a lot less each year than Advisor fees.  One major flaw in the Theory is that it says that buying bonds reduces Risk, which is nonsense.  But bonds are usually less volatile than stocks, and thus a Portfolio is deemed less risky if it has some bonds in it.  As Buffett & Munger say, this is twaddle.  And here’s another viewpoint which echoes theirs.  And when MPT says that you can only get higher returns by taking on more Risk, that too is complete malarkey: by its definition, a stock like Microsoft which falls 50% in price is now “Risky”, whereas for Cynergy Research it’s been almost completely de-Risked due to being massively on sale.  There is no way to reconcile reality with MPT: it’s a binary choice.

4. Closely tied to MPT as a cornerstone is the concept of “The Efficient Frontier”, which implies that all Portfolios are equal if they fit on a curve that maximizes “the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.”  This too is nonsense because some Portfolios might fit the curve but have low Volatility on a frequent basis, while others might have huge Volatility that happens infrequently (and risk permanent impairment or loss of Capital as a result).  This is no way to structure and run a Portfolio for a client. (Graph courtesy of Investopedia)

What is the alternative, you ask, if all of the above major theories need to be tossed out the window?

Well, the answer is tad self-serving, but it is to:

"Focus on the biggest, best, most resilient, profitable and growing publicly-traded companies in the world"

If we added up all the above benefits and attributes of this Strategy, plus: widespread geographic and industry diversification; dividend growth, stability, diversification, and tax benefits (for CDN shareholders of CDN stocks); share buybacks that over time result in higher ownership levels; reduced default risk; generally lower debt levels; fully- or mostly-funded pension plans; instant liquidity; long runways that reduce the need to sell frequently and trigger Capital Gains taxes; the demonstrable benefit of Founders leading quite a few of the companies; ability to sleep well at night; etc., we’d probably hit about 15-20 interlinked positive items. 

Name another Strategy that has that many layers of positive attributes and we will collectively take a look: perhaps there’s a better mousetrap out there, but in 45 years of investing and speculating I’ve never seen it, and I’ve been pitched almost every kind of investment vehicle you can imagine, and some you can’t.

Frankly, I think it is the best global investment strategy for the average and high-net-worth investor, and have put all of my own and our family money behind it, which numbers in the millions of dollars.  I also feel very strongly that the Cynergy Research Strategy provides our family and our subscribers with a competitive advantage relative to all the MBA’s and Finance types that follow some or all of those flawed theories outlined above.  The proof is in the numbers, and that’s the reason the Global Growth Model Portfolio has beaten the TSX Total Return Index handily by such a wide margin over the years.

Could we possibly tweak the basic Strategy by adding the yield-enhancement concept of selling “Covered Calls”? Actually, no.  If in the long run stocks are supposed to have an 8-10% Total Return for average companies (and likely even higher for our Model Portfolio companies), then it’s a dead certainty that you will have some of your stock positions “Called Away” on a regular basis because of steadily rising stock prices (or unsteadily – nothing ever goes straight up like an arrow), thus forcing you to re-buy the positions at a higher price, and therefore losing a fair amount of Capital Gains as a result, which in turn diminishes the potential Total Return over time.  It becomes a trade-off between income generation and Total Return generation, with the more important TR aspect losing.

Could we flip things around by adding the yield-enhancement concept of selling “Naked Puts”, like Warren Buffett does when he’s trying to acquire companies?  Actually, yes, at first glance, but more work needs to be done to validate the concept, which goes like this:

a)   If you like a company, and would be prepared to buy it, or buy more of it, at a specified lower price, and would like to obtain some “Option Premium” income in the process, then you sell a Put contract to someone which gives them the right to sell you a specified number of shares (100 per contract) for a specified time (the Duration) at a specified price (the Strike Price).

b)  Let’s say you sell someone a Put contract for 100 shares with a Strike Price of $90 when the underlying stock is trading at $100, and the Duration is 3 months. My guess is that you’d generate about $150 in Option Premiums, so if you did this 4 times a year you’d generate $600, or 6% on the value of the underlying shares.  Not bad, and it beats bond yields and most dividend yields.  During times of excessive Volatility the Option Premiums would increase in line with the Volatility factor, and as such your annual yield might rise to, say, 8% perhaps if you sold Puts during those tumultuous times.

c)   And again, if in the long run stocks are supposed to have an 8-10% Total Return for average companies, then it’s a dead certainty for some of the trades that you will never get the shares assigned to you because of the natural upward pull of market forces and the specific company fortunes in question.  But every once in a while you will get lucky, and also collect the Option Premium income along the way. Buffett uses the tactic to increase his ownership position in a target company at a discount, and get paid for it.  Smart guy, and just another reason he’s the 7th richest person in the world, which we should all want to emulate by learning from his and Charlie’s example.

d)  There is a Margin Requirement for selling Naked Puts, and it will vary from Broker to Broker but will usually require collateral equal to about 20% of the value of the underlying shares, plus the Premium itself, minus any out-of-the-money amount, or 20% times $10,000 + $150 - $1000 = $1150.  This is not an onerous amount to be posted for a US$10,000 bet, and if you have a large Portfolio in a Margin Account you’ve almost certainly got huge excess collateral anyway.

Hopefully the above sections have been of interest, as they underpin the entire Cynergy Research differentiated Strategy.

They also don’t teach that in any level of schooling.

Epilogue:

Well, just in case you think the above critique is without foundation, given that I do not have a PhD in Finance, it turns out that I am not the only person to begin questioning the 4 Pillars of Finance above. 

In an article in the Globe & Mail on September 7, 2024, the author (Ian McGugan) took aim at the Efficient Market Hypothesis via quoting a Paper written by Cliff Asness entitled "The Less-Efficient Market Hypothesis" which can be downloaded here. (Mr. Asness does hold a PhD in Finance and runs AQR Capital Management in Greenwich, Connecticut where he made his name (and a couple of billion dollars) by devising ingenious investing strategies based on deep dives into data.) 

Mr. Asness basically says there are 3 reasons Markets have become less efficient over the past 34 years or so:

1. Indexing has ruined the Market (via the rise of ETF's tied to various Indexes)

2. Very low interest rates for a very long period

3. The rise of Social Media that turns the "wisdom of the crowd" (where people operate individually, and the best ideas bubble up to the top) into a herd mentality (where they act in unison and lose all individual thought), coupled with online day trading by vast numbers of people.

Even Warren Buffett agrees with point 3, as he is quoted in the Paper as saying “For whatever reasons, markets now exhibit far more casino-like behavior than they did when I was young. The casino now resides in many homes and daily tempts the occupants."

We will look for more academic rebuttals of the 4 Pillars over time and add them to this list. 

And as a reminder, the purpose of this exercise is to simply remind people that they should not blindly follow Theories because there are almost always exceptions, and therein lies the path to generating Alpha.