Mini-Case:

Foreign Direct Investment

and Political Risk
 Mini-Case: Strategic Portfolio
Theory, Black Swans, and [Avoiding]
Being the Turkey
Put another way, investors are more volatile than
investments. Economic reality governs the returns earned
by our businesses, and Black Swans are unlikely. But
emotions and perceptions – the swings of hope, greed,
and fear among the participants in our financial system –
govern the returns earned in our markets. Emotional
factors magnify or minimize this central core of
economic reality, and Black Swans can appear at any
time.
– John C. Bogle, Founder of The Vanguard Group, before the Risk Management
Association, Boca Raton, Florida, October 11, 2007.
• Modern Portfolio Theory (MPT), like all theories, has been subject to much criticism. Most of that
criticism is focused either on the failings of the theory’s fundamental assumptions, or in the way the
theory and its assumptions have been applied.
• Ultimately, it has been accused of failing to predict the major financial crises of our time, like Black
Monday in 1987, the credit crisis in the U.S. in 2008, or the current financial crisis over sovereign
debt in Europe.

Criticisms of Modern Portfolio Theory

• Modern portfolio theory was the creation of Harry Markowitz in which he applied principles of
linear programming to the creation of asset portfolios.
• Markowitz demonstrated that an investor could reduce the standard deviation of portfolio returns by
combining assets which were less than perfectly correlated in their returns.
• The theory assumes that all investors have access to the same information at the same point in time.
It assumes all investors are rational and risk averse, and will take on additional risk only if
compensated by higher expected returns. It assumes all investors are similarly rational, although
different investors will have different trade-offs between risk and return based on their own risk
aversion characteristics. The usual measure of risk used in portfolio theory is the standard deviation
of returns, assuming a normal distribution of returns over time.
• As one would expect, the criticisms of portfolio theory are pointed at each and every assumption
behind the theory. For example, the field of behavioral economics argues that investors are not
necessarily rational – that in some cases, gamblers buy risk. All investors do not have access to the
same information, that insider trading persists, that some investors are biased, that some investors
regularly beat the market through market-timing. Even the mathematics comes under attack, as to
whether standard deviations are the appropriate measure of risk to minimize, or whether the standard
normal distribution is appropriate.
• Many of the major stock market collapses in recent history, like that of Black
Monday’s crash on October 19, 1987, when the Dow fell 23%, were ‘missed’ by the
purveyors of portfolio strategy.
• Statistical studies of markets and their returns over time often show returns which are
not normally distributed, but are subject to greater deviation from the mean than
traditional normal distributions – evidence of so-called fat tails.
• Much of the work of Benoit Mandelbrot, the father of fractal geometry, revolved
around the possibility that financial markets exhibited fat tail distributions.
Mandelbrot’s analysis showed that the Black Monday event was a 20-sigma event, one
which according to normal distributions (bell curve or Gaussian model) was so
improbable as not likely to ever occur. And if something has not happened in the past,
portfolio theory assumes it cannot happen in the future. Yet it did.
• The argument and criticism which has been deployed with the greatest traction seems
to be that portfolio theory is typically executed using historical data – the numbers
from the past – assuming a distribution which the data does not fit.

Any attempt to refine the tools of modern portfolio theory by relaxing the bell curve
assumptions, or by “fudging” and adding the occasional “jumps” will not be sufficient. We
live in a world primarily driven by random jumps, and tools designed for random walks
address the wrong problem. It would be like tinkering with models of gases in an attempt to
characterise them as solids and call them “a good approximation.”
-- Benoit Mandelbrot and Nassim Taleb, “A focus on the exceptions that prove the
rule,” The Financial Times, March 23, 2006.
 Black Swan Theory
• Nassim Nicholas Taleb published a book in 2001 entitled Fooled by Randomness in which he introduced
the analogy of the black swan.
• The argument is quite simple: prior to the discovery of Australia and the existence of black swans, all
swans were thought to be white. Black swans did not exist because no one had ever seen one. But that
did not mean they did not exist. Taleb then applied this premise to financial markets, arguing that simply
because a specific event had never occurred did not mean it couldn’t.
• Taleb argued that a black swan event is characterized by three fundamentals:
1. Rarity: The event is a shock or surprise to the observer.
2. Extremeness: The event has a major impact.
3. Retrospective Predictability: After the event has occurred, the event is rationalized by hindsight, and
found to have been predictable.
• Although the third argument is a characteristic of human intellectual nature, it is the first element which
is fundamental to the debate. If an event has not been recorded, does that mean it cannot occur?
• Portfolio theory is a mathematical analysis of provided inputs. Its outcomes are no better than its inputs.
The theory itself does not predict price movements. It simply allows the identification of portfolios in
which the risk is at a minimum for an expected level of return.
• Taleb does not argue that he has some secret ability to predict the future when historical data cannot.
Rather, he argues that investors should structure their portfolios, their investments, to protect against the
extremes, the improbable events rather than the probable ones. He argues for what many call ‘investment
humility,’ to acknowledge that the world we live in is not always the one we think we live in, and to
understand how much we will never understand.
 What Drives The Improbable?
• So what causes the “random jumps” noted by Mandelbrot and Taleb?
• A number of investment theorists, including John Maynard Keynes and John Bogle, have argued over
the past century that equity returns are driven by two fundamental forces, enterprise (economic or
business returns over time) and speculation (the psychology or emotions of the individuals in the
market).
• First Keynes and then Bogle concluded that speculation would win out over enterprise, akin to arguing
that hope will win out over logic. This is what Bogle means in the opening quotation when he states
that “investors are more volatile than investments.”
• All agree that the behavior of the speculators (in the words of Keynes) or the jumps of market returns
(in the words of Mandelbrot) are largely unpredictable.
• All that one can do is try and protect against the unpredictable by building more robust systems and
portfolios than can hopefully withstand the improbable. But most also agree that the ‘jumps’ are
exceedingly rare, and depending upon the holding period, the market may return to more fundamental
values, if given the time. But the event does indeed have a lasting impact.
• Portfolio theory remains a valuable tool. It allows investors to gain approximate values over the risk
and expected returns they are likely to see in their total positions. But it is fraught with failings,
although it is not at all clear what would be better.
• Even some of history’s greatest market timers have noted that they have followed modern portfolio
theory, but have used subjective inputs on what is to be expected in the future. Even Harry Markowitz,
on the last page of the same article which started it all, Portfolio Selection, noted that “... in the
selection of securities we must have procedures for finding reasonable ρ i and reasonable σij. These
procedures, I believe, should combine statistical techniques and the judgment of practical men.”
 What Drives The Improbable? (contd.)
• But the judgement of practical men is – well – difficult to validate. We need predictions of
what may come, even if it is generally based on the past.
• Kenneth Arrow, a famed economist and Nobel Prize winner relayed the following story of
how during the second world war a group of statisticians were tasked with forecasting
weather patterns.

The statisticians subjected these forecasts to verification and found they differed in no way from
chance. The forecasters themselves were convinced and requested that the forecasts be
discontinued.
The reply read approximately like this: “The Commanding General is well aware that the
forecasts are no good. However, he needs them for planning purposes.''
• Taleb, in a recent edition of Black Swan Theory, notes that the event is a surprise to the
specific observer, and that what is a surprise to the turkey is not a surprise to the butcher. The
challenge is ‘to avoid being the turkey.’

Mini-Case Discussion Questions

1. What are the primary assumptions behind modern portfolio theory?
2. What do many of MPT’s critics believe are the fundamental problems with the theory?
3. How would you suggest MPT be used in investing your own money?