Warren Buffett overturns all the main ideas of modern investment theory

Warren Buffett, alongside Benjamin Graham is considered to be the leading gurus of investment strategy. Though Benjamin Graham pioneered the notion of ‘value investing’, it was Buffett who consolidated the theory through repeated application. The consistency with which Buffett’s portfolio out-performed the average market results does prove beyond doubt the veracity of his ideas. His investment management company Berkshire Hathaway had consistently outperformed both the broader markets as well as competing investment funds. Yet, some of his ideas come across as counter-intuitive at first. For example, Buffett’s assertion that he buys stocks with no intent of selling them stands against the common practice of booking profits when the price is high. This essay will further elaborate how Buffett’s strategies differ from other contenting investment management theories.

Warren Buffett’s strong faith in a few fundamental ideas of investing puts him at odds with several other financial experts. More specifically, Buffett’s ideas are at odds with the principles entailed by the Capital Asset Pricing Model (CAPM) and its versions. Since the CAPM is based on the older Modern Portfolio Theory, it is important to learn the underlying assumptions behind both these theories. These two theories and their variants basically assume that investors try to minimize risk to the extent possible. Moreover, CAPM “assumes that investors have rational expectations concerning expected returns. Under this assumption, CAPM says that the expected return on an investment is equal to the risk-free rate of return plus compensation for the systematic risk of the investment in the usual sense…The systematic risk is measured by the degree of variability of the individual investment versus the market as a whole. It relates the risk premium associated with a particular stock (its return less the risk-free return) to that associated with the market as a whole.” (Sullivan, 1997)

Buffett found several weaknesses with both the MPT and the CAPM. Firstly, why should one give such importance to risk instead of focusing on security analysis as proposed by Benjamin Graham, wherein the investor would study the strengths and weaknesses of each company by looking at its financial strength, earnings prospects, debt levels, marketing strategies or many other measures that management use? (Schroeder, 2009) Further, there are other flaws in the modern portfolio theories as well. For example,

“investors are very concerned by downside volatility, but how many object when their portfolio moves up? Volatility is a measure that regards upside movement as equally bad as movement to the downside. What about inflation and the terrible toll it extracts on non-growth assets? Finally, speculative stocks which are extremely volatile do not fit into this mould as they certainly do not give superior returns, as a diversified group or otherwise. Right from the start this definition of risk seemed unrealistic. There are many problems with the whole concept. For starters there actually isn’t any permanent correlation between risk (when defined as volatility) and return. High volatility does not give better results, nor does lower volatility give lesser results”. (Schroeder, 2009)

Hence Warren Buffett’s criticism and scepticism over MPT and CAPM is based on sound reasoning. Another principle that Buffett strongly believed in is ‘less diversification’. Buffett believed that diversification is an insurance against ignorance, for which he got criticized by other leading investment gurus. But there is sound logic and rationale behind Buffett’s assertion. For example, as long as one studies the company, industry and the prevailing economic conditions one will be able to assess the future earnings prospects for the company. And since these parameters will vary between stocks and industries, the opportunity presents itself to pick the most under-priced of the securities. While modern portfolio managers would recommend a spread of 30 individual stocks, the portfolios of Berkshire Hathaway would show decidedly less diversification. Yet, Berkshire Hathaway has consistently outperformed competing investment management firms on a year-on-year basis. Hence there is indeed merit behind many of Buffett’s investment strategies, although they might at first seem counter-intuitive and risky (Sullivan, 1997).

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