Why I don’t use Modern Portfolio Theory

[i4value]

I am a fundamental investor who believes that you must have a portfolio of stocks. 

Unfortunately, when I tried to look for guidance on how to construct and manage a stock portfolio, all I could find was Modern Portfolio Theory (MPT)

MPT is a statistical technique that does not work for me. 

Firstly, I am a bottom-up stock picker where I select my stocks based on value investing principles. I identify my stocks one at a time. If I start from scratch to find 30 stocks that fits my value investing approach, it will take probable a year or two. MPT does not help in such a case.

Furthermore, MPT is about covariances. As a retail investor, I do not have the computing power to find the covariances for 30 stocks. On top of this, we all know that covariances are not stable. So imagine having to recompute the covariances periodically to keep track of the changes.

But more importantly, MPT is based on the view that risk is represented by volatility. I take the view that risk is more about a permanent loss of capital rather than volatility. So I have a different risk management approach.

Over the year, I had to establish my own approach to constructing and managing a stock picking portfolio that does not rely on MPT. Has it worked? I would that the results validate it. 

If you want to know more, go to How to manage a stock picking portfolio

[i4value]

I am a bottom-up value investor. This meant that the stock picking portfolio comprises of stocks that were selected  based on my value investing approach.

I do not plan my portfolio profile and go and look for stocks. Rather the portfolio profile is the results of the individual stocks that I have picked.  As such my portfolio construction process can be summarized as follows:

• Identify and invest in individual stocks.
  
• When I have about more than a dozen stocks, I then review the stock portfolio for diversity.
  

I have several portfolio guidelines to assess that I have the balance between risk and return. I look at 5 issues as illustrated by the chart.

[specuvestor]

I think the fundamental difference is how we define risk

MPT define risk as volatility that actually has a downside skew. That's why they can conclude that private equities, which selectively mark to market or provide monthly prices, are safer than treasuries in 2022. Buffett himself mentioned quite a bit on this eg why would risk increase when price goes down and decrease when price goes up

Fundamentals define risk as what we know vs what we don't know / cannot control and what can go wrong. Once this basis is established the rest eg which stock, allocation, concentration risk etc will follow

[i4value]

Yes, MPT uses volatility as a measure of risk while most value investor follow the permanent loss of capital view. The problem is that there are hardly any literature on how you manage risk, or construct a stock portfolio using the permanent loss of capital view.

[soros]

Mark Minervini is a very successful trader in the USA and manages his risk by choosing only stocks which are in strong uptrend. He used "swing trading" method in 2021 to gain over 300% on his US $1 Mil outlay and become champion investor . You may find his book in your local library or you could buy the book from Amazon online bookshop.

[i4value]

I am not sure whether stock traders think in terms of a stock portfolio in the MPT context. I suspect that Mark Minervini portfolio is merely a collection of the momentum stocks he is trading at that point in time.