To understand the gist of portfolio theory, let's look at a simple but appropriate metaphor. Say we are flipping a coin, and 1,000 people are guessing the results of each flip. In real life, millions of people trying to guess the future performance of tens of thousands of financial instruments isn't qualitatively different.

Statistics 101 describes two salient results:

1) As the number of flips increases, the accuracy of all guesses by all people together converges on 50%. This inexorable trend lies at the heart of portfolio theory -- the more different investments you make, the less exposure you have to isolated runs of luck, both good and bad.

2) After N coin flips, the accuracy of guesses graphed by individual will form a bell curve. Most people will be around 50%, but the single luckiest individual will have guessed right much more often than 50%, and the single unluckiest individual will have guessed right much less than 50%. This is a normal statistical distribution.

North says portfolio theory 'cannot accept the existence of Warren Buffet.' Exactly the contrary is true. This theory *predicts* the existence of Warren Buffet, and also predicts that he won't be you. According to portfolio theory, Buffet just happens to be the single individual furthest out on the tail of the predicted bell curve.

Now, why would North attempt to discredit a thoery on the amazing grounds that it actually works? Is it because North got his Ph.D. despite flunking statistics 101? Or is it because North is wrong if portfolio theory is correct? And if your opinion is contradicted by a theory that works, what do you do? Well, you can question your opinion, or you can lie about the theory. North chooses the latter. As usual.

On the real evidence, North has a strong case. Why do this?

And why hasn't the market reacted to y2k? I can think of many possible reasons (y2k is a hoax; the market movers know they'll be ready but their lawyers won't let them admit it; the market *has* discounted y2k and it would otherwise be at 12,000 today; the market movers have their heads in the sand and need a couple of good celebrity failures to wake them up; it's still too early for the market to react; y2k is too far outside the box for the market to take into account, etc. etc.) The question is, how do we test any of these theories? I'm not comfortable with the strategy of rejecting all theories that don't fit my a priori convictions.

-- Flint (flintc@mindspring.com), November 05, 1998

Answers

Try reading _Extraordinary Popular Delusions and the Madness of Crowds_ by Charles MacKay for a different take on market theory. Assuming that market behavior can be predicted by statistics alone ignores the human element altogether. Market manias (like the current one) have historical precedent. They also have drearily similar outcomes... .

This market is ignoring y2k just as it is ignoring the rapidly looming bad news from numerous other fronts. That's the human equivalent of lemming behavior, not rational decisionmaking or even elementary statistics. Today's market is a grownup game of musical chairs- don't get left standing!

nemo... (Not an economist, don't even play one on the Internet)

-- nemo (nemo@deepsix.com), November 05, 1998.

No one who deals regularly in financial markets for a living accepts the academic view of the markets. It is not even remotely considered as a serious option. You may as well tell them the Earth is flat. Well, except that would have more credibility. MPT is laughable in the extreme, IMHO.

That aside, why is the market still "rising" despite Y2K? First, "the market" is not. The Dow 30, S&P 500, & Nasdaq are. So are the Russell (small stocks) & broad market (Value Line) - but they're still well below their lows (especially the small stocks, which are still down more than 20% even after their recent rally).

You must remember that stocks have an extremely unfortunate tendency - repeated throughout history - of rallying, often to all-time highs, right before disaster strikes. This happened in 1906/7 before the Panic of 1907, before the Crash of 29, before the horrid bear market of 73-74, before the Crash of 87, & before the 1990 recession. There is nothing unusual about this at all; it is common. In virtually every one of those cases, the market was either at, or very near, all time highs - just before it completely fell apart. And all anyone saw was more good times around the corner. Eeeeee-yep.

As far as I am concerned, Y2K will indeed bring a recession. And a subsequent decline in stocks. IMVHO only. Well, and Ed Yardeni & a few others.

Drew Parkhill/CBN News

-- Drew Parkhill (y2k@cbn.org), November 05, 1998.

Gosh, I'm not as economically educated as you guys are and Dont understand half your terms, but even a bumpkin like me can see those guys are still playing the market because there is still money to be made there and greed will make em dart among the flames trying to make a buck up till the bitter end. they are all counting on their agility to profitably leap clear before TSHTF.

-- Ann Fisher (zyax55b@prodigy.com), November 05, 1998.

If the lights go out, do you think portfolio theory will matter? Do you think the Dow will be in the 8,000 range? If you want to trade stocks post y2k, you may have to move to NYC and join the NYSE. Seats on the exchange should be inexpensive. No electricity, no market. In this y2k shell game, I am keeping an eye on the electricity issue. No one has convinced me that the lights won't go out for an extended period of time. Without power we plunge into a world we know nothing about. Portfolio theory wasn't a hot topic in the 1800's and won't be in the early 2000's.

I too, enjoyed McKays, "Madness of Crowds". Tulip bulbs were my favorite.

-- Bill (bill@microsoft.com), November 06, 1998.

Common sense tells me that Wall Street has to do something with all those 401K plans. IMHO, it's the little guy who is going to lose it all.

The Big Boys already know who will make it and who won't. There is alot of talk about "Flight to Quality" being bounced around by those in the know.

Best regards,

Anna

-- Anna McKay Ginn (annaginn@aol.com), November 06, 1998.

As I remember my Miller and Modigliani, their theory holds that no individual can consistently outperform the market.

The theory does not say that 50% of individuals (to the right of the bell-curve peak) can consistently outperform the market to some extent. Remember, the "market" is defined as an average return. The theory attacks the concept of "consistent outperformance" at its root.

Miller & Modigliani's premise rests on the notion of "perfect information," and other sophisms of modern economics. North is spot- on in his critique of this basic fallacy.

An no, statistics is not the "father of economics" - i.e., more fundamental than economics. At best, it is extraordinarily useful for identification of emerging patterns in industry. But as a tool of theory? The wreckage of modern economic thought is riddled with cancers such as these. Thoughtful human behavior is not guessing or coin-flips.

Trained as economist...working as an economist...passed statistics.

-- Sutherland Ellwood (ACESCE1@AOL.COM), November 06, 1998.

Bill: no, I don't expect the Dow to hold in the 8000 area, as I've stated publicly several times. However, the issue as you originally posited it had nothing to do with MPT & electricity- that's a separate matter. I would guess that my previous statement that "Y2K will indeed bring a recession" would clearly imply a stock devaluation from the current record PE levels.

Sutherland: good post.

Drew Parkhill/CBN News

-- Drew Parkhill (y2k@cbn.org), November 07, 1998.