davidbau.com

I Blame Markowitz

The world is pouncing on Greenspan's mea culpa, marveling at how ridiculous it seems that he believed that banks would responsibly manage their own risk.

"I still do not fully understand why it happened," he says.

And the punditry is astounded: how could he be so naive as to be blind to the greed everywhere on Wall Street? How could we be so gullible? But when I look around, I don't really see Gordon-Gekko-style problems with greedy bankers. I see a bunch of bespectacled geeks that have been working hard to do what they think is the best thing. Somehow, to their collective amazement, they have all lead us into calamity.

If the issue is neither greed nor malice, what is the problem?

I have an idea where to place the blame.

The culprit is a powerful meme of intellectual laziness that has infected the financial community for the last half century: Modern Portfolio Theory, the mathematics of reducing risk through diversification.

The new alchemy of mixing investment portfolios has overtaken the old-fashioned discipline of evaluating fundamentals of individual investments. MPT is the dangerous meme that made this possible.

What is Modern Portfolio Theory

Modern Portfolio Theory is an attempt to mathematically minimize investment risk. The idea, invented by Nobel-winning economist Harry Markowitz in the 1950's, dissects the balance between fear and greed. It asks the question "what is the right tradeoff between risk and return?"

Remarkably, this philosophical question has a mathematical answer.

The Ideal Portfolio

Markowitz discovered something that should have put financial advisors everywhere out of business: he proposed that since everybody can reduce risk by going into cash, there is actually only one single best portfolio of risky investments for everybody.

But why, and which portfolio? His construction is simple geometry - if you plot out the set of possible cashless portfolios as a nice convex blob of risk versus return, then the the ideal portfolio is the one that maximizes the straight ratio of return divided by risk.

Markowitz did not say that the risk/reward mix of the ideal portfolio is right for everybody.

But what he did point out is that if you wanted more risk or less risk, you would be better off mixing the ideal portfolio with cash or debt, rather than picking a different portfolio of risky investments. The ideal portfolio is chosen so that the straight line of risk/reward you get by mixing cash with the ideal portfolio will sit above all possible other portfolios points. Thus return is maximized, Q.E.D.

With that picture and proof, Markowitz established the concept of the Ideal Portfolio and plunged the first mathematical stake into the unholy monster of Risk. For this, he won a Nobel prize.

The One True Way

Markowitz's theory that there is One True Way is amazingly seductive and has attracted a generation of mathematical economists and investors to Find The True Path. The simplicity and certainty of the Markowitz meme has become the religious foundation of modern finance.

Without Markowitz's Ideal Portfolio, Adam Smith's invisible hand is a mere phantom, an exhortation that we should never get too cocky, a warning that it is impossible to beat the market in the end. The idea of the perfect market is a warning that we can never trust any one clever investing idea too much.

But with MPT, efficient market apologists get something better than a negative warning. MPT gives them a positive goal that they can preach to investors: the Ideal Portfolio.

Intuitively Unsettling

For any seasoned investor, the suggestion that there is One Right Way For Everybody should be intuitively unsettling. If everybody is going the same way, then where is the zag to balance out my zig?

Is there any room for real insight and differentiation in the investing world?

To a seasoned investor, the "Oneness" of Modern Portfolio Theory gives you a little itch and reminds you of an oddly focused fad in tulip varieties, or a strange enthusiasm for online pet stores. Is it really true that "everybody is right?"

Maybe Markowitz was wrong.

The Myth of Unsystematic Risk

The current collapse has at its root a couple basic banking errors: the artificial suppression of the Chinese Yuan and the Japanese Yen that sent trillions of dollars of economic surplus looking for a home in the West, and the foolish application of the religion of Modern Portfolio Theory to find a home for this money.

What makes MPT so dangerous?

MPT is dangerous because of the culture it has encouraged.

MPT is dangerous because it preaches the false idea that the only way to reduce unsystematic risk is to diversify it away. The famous diagram of risk versus return implicitly assumes that specific risk is fully random, and that the only way to manage risk is through averaging.

However, in the real world, there is plenty of risk that is neither random nor global. There are specific business ideas that are truly destined to succeed or fail. There are specific people who true talents or incompetents. The world is not information-free and not all events in the world are unpredictable.

MPT tells you exactly how to diversify perfectly in a perfect-information world.

Unfortunately, for most investments, this is just a waste of time.

Repackaging Trash

Most of the world's investments are in prosaic forms like small business loans and homeowner mortgages.

At the scale of one mortgage, the future is not random. A mortgage represents a person with a specific job, with specific savings and a specific family, health, education, spending habits, dreams, and priorities. And despite the fact that every borrower is so different, everybody generally gets about the same mortgage interest rate. The mortgage market is clearly, obviously, certainly, an inefficient market with plenty of room for improvement by clever lenders.

The right way to reduce risk in an inefficient market is not to diversify, but to collect and analyze more information so that you can come up with a better price for each borrower.

But under the religion of Modern Portfolio Theory, the role of the banker is redefined. An MPT banker knows "you can't beat the market" by picking a price. Instead of attempting price discrimination, bankers now "manage risk" though a lot of diversification busywork.

With MPT, bankers can proclaim proudly that their portfolios are not only the best in the world, but Mathematically Ideal. No other portfolio in any possible universe could be better.

But in the end, if all you are doing is mixing investments, the exercise comes down to holding your nose and putting a bunch of trash in a bag. When you are all done, you still have a bag of trash.

The Tulip Problem

Portfolio theorists would point out that they are perfectly aware of high risks and that there is nothing wrong with that - the numbers may be bigger, but they are still carefully measured and plugged into their models.

What is wrong with that?

The problem occurs when all the buyers in the market hold the same belief in randomness. When all the buyers assume that surprises are essentially unpredictable, the sellers have an easy time coming up with predictable surprises - they have no reason to play fair.

When all the mortgage lenders believe in a perfect market, they are all wrong. Mortgage takers - mortgage brokers, home refinancers, home developers - win by discovering the blindness of lenders and borrowing as much as they like.

Without buyers who doubt the validity of the market, you have no market.

In a world of market-believing, model-following, computer-automated MPT buyers, failures no longer happen because of "risk". Failures happen because of self-delusion. Through all the math, we bottom line is that the Ideal Portfolio recommends buying tulips only because everybody else is buying tulips.

MPT is the cultural blindfold that has deceived us all.

Posted by David at October 25, 2008 04:40 AM