Modern Investment Theory

While this is about the epistemological foundations of Investment Theory, I think it might be of wider interest…

Most students of “Modern Investment theory” (as taught in most business schools) come away with the idea that above-average returns [known as “positive alpha“] are not possible to any investor (or, at very least, are not possible to most).

This is not about students being told that knowledge of investing is still in its infancy; that’s not the point. Rather, they’re taught that in principle, regardless of such knowledge, it is impossible to make above-average investment decisions. Indeed, if anything, further improvements in knowledge actually reduce the chances of making above-average decisions. In effect, the knowledge is futile in this particular field.

This post is not a critique of modern theory. Instead, I want to make the positive case for modern theory, to explain its plausibility. I also invite comment on the accuracy with which I portray it — for I do not intend to build a strawman. At this point, I am not interested in explanations about what’s wrong with the theory. I want to understand it before launching into criticism.

Context-setting: The context here is the buying and selling of tradable financial instruments, in a non-managerial fashion. Things like starting one’s own business or owning art-work include other factors and are outside the scope of this discussion.

The “modern” position: The futility of making investment decisions is simple to explain with an example. Suppose there are two companies: A and B. For the sake of argument, suppose that Investment Science has reached a stage where we can make excellent estimates about how the shares of each company are going to perform.Can we then use this knowledge and buy shares in the better company (say, Company-A)? I submit that we cannot. This is because enough investors would have gone to college and learnt the same Investment Science. They too will know that Company-A is better and will have reached similar conclusions as to the relative worth of the shares of these two companies.

In this situation, the prices of the shares of these companies will reflect the underlying estimates of their worth. So, if the shares of A are estimated to be worth twice the shares of B, then the price will reflect this. Therefore, with a given amount of cash, one would be able to buy a certain number of shares of A, or twice the number of shares of B.

Paradoxically, a person who knows nothing about investment theory could do just as well as the experts because the price at which the shares sell are always fairly close to the best-estimated value as calculated by the experts of Wall Street.

A common metaphor is that a “monkey throwing darts” at the stock-listing page of the Wall Street Journal can come up with a portfolio that will do “just average”. Even if experts are a little better than average, we are told, one has to pay them for their services. Doing so, brings the net result back to average. We’re also told that most Wall-Street funds do worse than average after one deducts the commissions of the experts. This has led to the advocacy of index funds. Importantly, while modern theory might lead one to index-funds, rejecting modern-theory does not mean that one must reject index-funds.

At this point, my questions are as follow:

  • Have I represented the modern position correctly?
  • Is there a better pro-Modern position to be made?

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