Date: 11-May-98 — 2:27 PM

Subject: Warren Buffett vs Modern Finance Theory ?

From: George

Catherine Odelbo’s current article at the Morningstar site caught my interest -

text.morningstar.net/cgi-bin/GetNews.exe?NewsStory=MS/StockAnalystsJournal/sj980508.htm

Her opening sentence is I don’t understand why business schools don’t teach the Warren Buffett model of investing. Or the Ben Graham model. Or the Peter Lynch model.

Is there too much credence given to the Modern Finance Theory? The Efficient Market Theory? Capital-Asset Pricing Theory? etc from academia?

- at the expense of the basic one-foot hurdle ideas of common sense?

Any opinions out there?

Date: 11-May-98 — 3:03 PM

Subject: RE: Warren Buffett vs Modern Finance Theory ?

From: Bylo

I also read this piece on the weekend. For everyone’s convenience Catherine Odelbo.

There are at least four more recent Buffett-related articles on the M* site (not all of which I’ve read yet):

I too am interested in people’s reactions to this.

And just to stir things up some more, here are a couple of Buffett quotes

I’m a huge admirer of John Bogle and what he’s written.

Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

Date: 11-May-98 — 3:56 PM

Subject: RE: Warren Buffett vs Modern Finance Theory ?

From: PK

Hi George -

My first reaction to Ms. Odelbo’s article is that she doen’t know what she is talking about. When I got my MBA, Graham & Dodd were required reading (we didn’t read Buffet or Lynch, but that tells you more about my age than business school curriculum).

MPT provides a framework from which all other ideas can be evaluated against. Has Ms. Odelbo ever looked at the THOUSANDS of academic articles that test MPT, or CAPM or alternative valuation models? It sure doen’t sound like it. Maybe she should examine the writtings of Fama, or Jensen or dozens of others who have examined the subject.

Here’s just one example of how academic scrutiny has moved finance theory forward. CAPM, for which William Sharpe won a nobel prize, is a single factor model. It trys to explain market performance via one dimension — namely systemic risk. It has been found to lack robustness in its predictions. This has motivated Fama and French (two academics) to develop a 3 factor model. It is based on three types of risk — market, company size, and value vs growth. It explains variability in returns better than CAPM, and by the way the basics of the growth vs value continum are, to some extent, based on the stock selection disciplines of Graham (ie low P/Es, low book/value, etc.).

Other academics have also attempted to extend the capabilities of CAPM. Ross developed arbitrage pricing theory (APT) which is a 6 factor model (or maybe 5, I can’t remember). At any rate the point is there exists considerable academic debate. And this debate can progress via systematic rather than ad hoc approaches.

Ms. Odelbo writes like academics are somehow part of an MPT cult, chanting the efficient market — CAPM mantra. This is absurd and suggests her fundemental lack of knowledge concerning both finance theory and human nature when it comes to debate.

Date: 11-May-98 — 6:19 PM

Subject: RE: Warren Buffett vs Modern Finance Theory ?

From: Scanner98

Just started reading Ron Dembo’s book, Seeing Tomorrow. His main thrust is in regard to risk. Haven’t read enough of it yet to see how he’s treating it. Anyone read the whole thing?

Date: 11-May-98 — 6:26 PM

Subject: RE: Warren Buffett vs Modern Finance Theory ?

From: thbox

Hi PK -

There is (an attempt at) a sustained critique of MPT in The Canadian Mutual Fund Bible (in Chapter 6, and in an appendix.) I would appreciate your view on it.

(If you don’t want to buy it, I think most libraries have it.)

Date: 11-May-98 — 7:32 PM

Subject: RE: Warren Buffett vs Modern Finance Theory ?

From: PK

Hi thbox-

I’m actually planning to buy your book as I feel its my moral duty to support fund library contributors (BTW, your book is available frugally at The Real Canadian Superstore). I’d be happy to give you my comments on your critique of MPT (I’m flattered you would ask).

Date: 11-May-98 — 7:44 PM

From: thbox

GCS bought 600 copies — so many and at such a discount to retail that the publisher cried poor and said we couldn’t have our regular royalty. Boo hoo. -)

thanks

Date: 12-May-98 — 1:21 AM

Subject: RE: Warren Buffett vs Modern Finance Theory ?

From: Jay Walker

I personally find the efficient market theory verging on hilarious!

I hope the academics continue to come up with more drivel like this, as it makes it easier to find stocks which will outperform the market, given that investors will simply quit trying to do so.

Bylo, didn’t that quote from Buffett include the phrase ‘know nothing investors’. I thought it did. I may be wrong though.

Cheers!

Date: 12-May-98 — 6:55 AM

Subject: RE: Warren Buffett vs Modern Finance Theory ?

From: Bylo

PK, thbox, et al, speaking of buying books frugally, any suggestions for doing it over the Internet. Amazon is fine for Amurricans with its 30% discount, but by the time one pays for shipping to Canada and the $5 GST collection fee it’s no cheaper than paying list at the local bookstore.

Jay, not that I can see. Here’s the entire section from his 1996 report to shareholders: Let me add a few thoughts about your own investments. Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word selected: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.

To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses — How to Value a Business, and How to Think About Market Prices.

Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards — so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.

Though it’s seldom recognized, this is the exact approach that has produced gains for Berkshire shareholders: Our look-through earnings have grown at a good clip over the years, and our stock price has risen correspondingly. Had those gains in earnings not materialized, there would have been little increase in Berkshire’s value.

The greatly enlarged earnings base we now enjoy will inevitably cause our future gains to lag those of the past. We will continue, however, to push in the directions we always have. We will try to build earnings by running our present businesses well — a job made easy because of the extraordinary talents of our operating managers — and by purchasing other businesses, in whole or in part, that are not likely to be roiled by change and that possess important competitive advantages.

Date: 12-May-98 — 9:56 AM

Subject: RE: Warren Buffett vs Modern Finance Theory ?

From: George

To PK -

I am not an expert on MPT. The only readings I’ve done on it are the books by Burton Malkiel and Frank Armstrong and that is not very much. As time allows I hope to delve into it more. I may or may not accept it eventually. At the moment I am skeptical.

The parts I DO accept are the nearly efficient market theory, its accompanying nearly random walk in stock selections and so the investor value of low-cost-index-funds as a good long-term investment vehicle. Both my 30 years of experience in low-level investing and this nebulous thing called “common sense” are my reasons for accepting this.

It seems to me that one of the main underpinnings of MPT is the equating of “risk” with the fluctuations [variance or standard deviation] of the market price. I am not comfortable with that kind of foundation stone. I keep wondering if the main rationale for it was something like this — because variance was the ONLY quantifiable variable resembling “risk” to Marry Markowitz in 1950 – he used it as there was no alternative. A lack of alternatives rationale does not necessarily lead to a sound theory.

The whole business of economics and its related financial investment theory is an incredibly complex process – that may have a logical and predictable underpinnings or it may not. Its basis may be unpredictable and chaos-like. Because experiments [validation tests] of these ideas seem nearly impossible today – I think being skeptical is the better perspective.

I’m not always in awe of academic enterprises. There is a strong herd [or lemming?] instinct in academic research today [and it’s not unique to economics] – in part because of the fund granting system and the need to publish-or-perish for tenure requirement. One does not always get good skeptical views against mainstream orthodoxy within academia. Being mainstream can be a very conservative constraint. The Nobel Prize is part of that mainstream.

As a reminder, to quote John Kennedy “How could I have been so mistaken as to trust the experts?’

But having said all of the above I don’t think that MPT is necessarily “wrong”. It may be correct. It may be partially correct [the more likely scenario if you ask me]. And it may be wrong in some way we do not yet understand. I just don’t think we should swallow MPT as gospel — hook, line and sinker — today.

Date: 12-May-98 — 12:28 PM

Subject: RE: Warren Buffett vs Modern Finance Theory ?

From: ex bond trader

Good source for books ( mail order ).

C.W. Hay Bookseller 1-800-567-0568

Date: 12-May-98 — 2:29 PM

Subject: RE: Warren Buffett vs Modern Finance Theory ?

From: George

I’ve been looking around the web for readings on Modern Portfolio Theory. Any suggestions of better sites would be welcome.

viking.som.yale.edu/will/finman540/classnotes/notes.html

It looks interesting. It is a course at Yale. I have not read it yet.

And I will try [but probably fail] to provide a link as well:

Date: 12-May-98 — 3:12 PM

Subject: RE: Warren Buffett vs Modern Finance Theory ?

From: Richard Deschene

Just a bit of Devil’s Advocate here.

I do find all of these market and portfolio management theories interesting, but ultimately if you invest in indice(s) of markets with high levels of disclosure, do you not get a (weighted) amalgam of these theories as they are being put into practice? Clearly that’s rhetorical.

Some single method will prove the better performer 10 years hence, assuming the variability between methods is >0. (mind you, by random chance alone some random selection of 5 stocks will outperform 20 other, random selections of 5 stocks; 10 years hence) And if a disproportionate number of investments are made based on this proven 10 year history, guess which theory will now have the greatest effect on the index in question? When looking at anecdotal evidence, this is called a self-fulfilling prophecy. But like I said, just playing devil’s advocate here.

Date: 12-May-98 — 3:26 PM

Subject: RE: Warren Buffett vs Modern Finance Theory ?

From: gummy

George: you might spend a pleasant afternoon wandering thru’