Yet Markowitz made two faulty assumptions. First, he ignored serial correlation. He assumed that the joint distribution of returns on stocks and bonds is just like flipping a coin. Every time you flip, the probability of heads and tails is the same. "It's like a coin flip in that the probability of returns tomorrow is the same every day," Brock says. The Markowitz theory assumes that the probability of stocks' and bonds' return tomorrow is the same every day. The solution is to keep rebalancing your portfolio to keep it 60% in stocks, 40% in bonds.
To show the folly of that assumption, Brock uses a weather analogy. For people who live in Tahiti, he says, the probability of rain or sun is the same every day. A coin flip. But what if you live in Vermont? The mean temperature for the year is 43 degrees. But the mean temperature in winter is 18; in summer, 73. Likewise, the mean average for the stock market price is 14 times earnings. But in 1981 it was 8. In 2000, it was 30.
The probability of the joint distribution of returns of stocks and bonds is not the same on a day in 1981 as a day in 2000. "The good news is that Paul Samuelson in 1969 said there is no optimal portfolio," Brock says. "It depends on the state of the world." Markowitz would be right if the conditions in the world were always the same, like the weather in Tahiti. But the return on stocks and bonds depends on many things, including whether it is a bear market or a bull market.
The second mistake is that all modern finance assumes stationarity, Brock says. "It assumes that the probability doesn't change." But the problem is that the process is random rather than deterministic. Stationarity assumes that the way you go from summer to winter and back again is always the same. "All modern finance assumes stationarity," Brock says. "But finance is all about structural changes and how we interpret them: What changes will an Obama administration make? What will China do? What about global warming? We don't live in a world that is stationary."
Instead, everyone is wrong, he says. Markets don't price things correctly. One person will not ever know the entire truth, he might just be less wrong. "If you want to make money, you have to be ahead of others in predicting structural changes," Brock says. "If your theory of connecting the dots is less wrong than mine, you make more money. No one knows how the stimulus package will work or how global warming will play out."
The true source of market volatility is mistakes, Brock says. Just as Galileo's physics was wonderful in a simplified world with no friction and no air, modern portfolio theory would be fine in a world with no mistakes. MPT did not assume that people knew the weather but that they knew the probability. Mistakes are what generate risks.
"The world is not knowable just by crunching the data," Brock says. "I am forced to have my theory. I connected the dots better than you did. The main point is simple: Portfolio theory created a fantasy world of perfect hedging.
The crucial mistake in portfolio theory that Samuelson pointed out was that you don't live in Tahiti. There is nothing to rebalance to."
MPT assumes that there are no structural changes. "Nothing changes so you just punch in the data and you optimize A robot can compute Markowitz. That's what consultants have been doing for 40 years, optimizing for the correct portfolio," he says.
But that's wrong, Brock says. Instead, you need to constantly change the portfolio to keep it in line with the structural changes going on in the world.
Efficient market theory assumed people were rational. That's wrong, as behavioral finance continues to show. Aristotle was wrong because he thought the sun went around the earth. That doesn't make him worthless. It just makes him dated. "Biases, mistakes. It doesn't matter why, but it only matters that we're wrong."