Early in my career I was fed large helpings of “Modern Portfolio Theory (MPT)”. We had this wonderful optimizing software that would place a portfolio on the “Efficient Frontier” and score it based on a variety of risk and return measures. The “Efficient Market Hypothesis (EPH)” is the cornerstone of MPT. It goes like this:

The efficient market hypothesis (EMH) is an investment theory that states it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can possibly obtain higher returns is by purchasing riskier investments.

Utter hogwash!


If you click into the article from which I stole the above quote, you’ll find that Morningstar (the mutual fund rater) confirms EMH — citing that most mutual fund managers don’t beat their benchmarks.


But here’s the thing — the one thing we know for sure — the ultimate factor that moves markets is moment by moment decision-making among the Earth’s 7 billion humans. And, you have to agree, we humans are anything but efficient decision makers.


As for Morningstar’s findings, well…. poppycock! Mutual fund managers’ professional lives are rife with constraints, conflicts of interest and the fear of getting fired (if they don’t hug their benchmark closely enough — thus, their fee becomes their hurdle). Using their sub-par relative results to support EMH is like saying a Ferrari can’t do 200 mph when it’s been equipped with a speed governor that keeps it below 100. Please don’t spin out over my reference to Ferraris and investing; my family says I drive our SUV like a grandma…


Here’s Warren Buffett on the topic:

“Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards.”

And:

“I’d be a bum on the street with a tin cup if the markets were always efficient.” 

Here’s surgeon and author Atul Gawande on human judgment:

Three decades of neuropsychology research have shown us numerous ways in which human judgment, like memory and hearing, is prone to systematic mistakes. The mind overestimates vivid dangers, falls into ruts, and manages multiple pieces of data poorly. It is swayed unduly by desire and emotion and even the time of day. It is affected by the order in which information is presented and how problems are framed. And if we doctors believed that, with all our training and experience, we escape such fallibilities, the notion was dashed when researchers put us under the microscope.

Again, we humans are not an efficient-minded bunch.

Here’s Gawande on uncertainty:

The core predicament of medicine — the thing that makes being a patient so wrenching, being a doctor so difficult, and being a part of a society that pays the bills they run up so vexing — is uncertainty. With all that we know nowadays about people and diseases and how to diagnose and treat them, it can be hard to see this, hard to grasp how deeply uncertainty runs. As a doctor, you come to find, however, that the struggle in caring for people is more often with what you do not know than what you do. Medicine’s ground state is uncertainty. And wisdom — for both patients and doctors — is defined by how one copes with it.

Allow me to apply the above to the predicament of investing by changing a few words:

The core predicament of investing — the thing that makes being an investor so wrenching, being an adviser so difficult — is uncertainty. With all that we know nowadays about people and markets and how to assess and approach them, it can be hard to see this, hard to grasp how deeply uncertainty runs. As an adviser, you come to find, however, that the struggle in caring for people is more often with what you do not know than what you do. Investing’s ground state is uncertainty. And wisdom — for both investors and advisers — is defined by how one copes with it.

That’s reality folks, the future is forever uncertain. There’s no knowing what tomorrow brings. So the best we can do is assess existing trends, apply Newton’s First Law (read probabilities) to our investment process, and calmly cope with whatever the future delivers.