How to Become a Billionaire Alexandra Dogaru
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very investor’s goal is to beat the market at the lowest possible cost, measured by risk. However, not every market participant can achieve such a performance. Because of the way financial markets are designed, for every win there is a corresponding loss. With the development of the Modern Portfolio Theory, most analysts’ perceptions of risk and return have changed. The secret? Diversification. Even though research in finance has proven that diversification has its advantages, some wealthy and successful investors, such as Warren Buffett, argue against it. To begin with, those in favor of the Modern Portfolio Theory, which states that for every reward, there is a corresponding risk, claim that diversifying one’s investments across different asset classes or securities can help achieve a stable return. Spreading investment risk is based on simple statistics such as standard deviation, and correlation coefficients1. In other words, for investors to secure their portfolio’s return against risk, they
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should employ statistical models that minimize the level of risk for each additional percentage point increase in return. On the other hand, there is plenty of evidence that rejecting the Modern Portfolio Theory can bring outstanding results, and the most remarkable example is Warren Buffett. As Frazinni et al.2 point out, Buffett’s success has mainly been due to his ability to construct a theory of investing that focuses on navigating high risk, instead of avoiding most of it. This approach contradicts the Modern Portfolio Theory, more specifically its claim that investors should invest in multiple asset classes to avoid the risk of owning only a few risky securities. One common statistic used to calculate the return per level of risk is the Sharpe ratio. To find the Sharpe ratio, an investor takes the portfolio’s return, subtracts the risk-free rate, and then divides this difference by the standard deviation of the portfolio’s return. The higher this ratio, the better a portfolio or an indexfund is managed. Frazinni et al.3 also show
that Buffett’s Sharpe ratio, which is consistently above the market’s, does not compare to what most professionals demand. In other words, it seems that Buffett can earn significant returns per risk, but since his Sharpe ratio is below standards, it implies that there must be an additional factor that contributes to his long-lasting success. Buffett has an investing advantage compared to his competition, the investment fun ds. For example, Ellispoints out that most investment funds tend to underperform relative to their benchmarks. So, it seems that there must be a secret in investment theory that differentiates Warren Buffett from other investors. One suggestion is that most fund managers tend to be active investors, meaning that they aspire to beat the market by constantly buying and selling securities. As Ellis5 states, one major drawback of excessive buying and selling of securities relates to the costs associated with numerous trades. In other words, it seems that active trading is not the key to success, because after all, nothing is free in