# Modern Portfolio Theory And Index Funds

Summary of Modern Portfolio Theory: "Diversify".


Modern Portfolio Theory is all about maximizing the expected retur
n at any given risk. Or minimizing the risk at any given expected
return. So it's just solving a type of optimization problems.

Expected returns follow a normal distribution (lol). If you assume
otherwise, it is Post-Modern Portfolio Theory (lmao even). The sta
ndard deviation is the risk. And

[Risk of an asset]
= [The market risk] + [The individual risk].

But you can remove the individual risk if you diversify the portfo
lio. Therefore linear combinations of the market portfolio (an ide
alized index fund) and the risk-free asset (an idealized short-ter
m government bond) gives you the solution of these optimization pr
oblems. Because you removed every unessential risk for any expecte
d return.

On the risk-return plane, the line made by those linear combinatio
ns is called the capital market line. And it is the tangent line f
rom the 100% risk-free portfolio to the efficient frontier (the cu
rve that consists of risk-efficient portfolios without the risk-fr
ee asset).


Long story short, Modern Portfolio Theory says that you should buy
just index funds and nothing more. You can explain it with Efficie
nt Market Hypothesis too. If free market is really that efficient,
why don't you have just the market portfolio? It's efficient!

Is it true? Well, it is somewhat justified by data. In the long te
rm, most investors (including professional fund managers) actually
cannot beat the market.

But like Nassim Taleb criticizes, the normal distribution assumpti
on is unreal and it is not immune to a black swan. As usual, histo
rical data is overrated in the theory. He recommends the barbell s
trategy for a black swan instead. It is basically [90% doomsday pr
epper] & [10% YOLO crypto gambler] strategy. By that, you can get
insane returns when a black swan happens while you can limit your
loss to only 10%.

Also, for a resource allocation of the economy, this is terrible t
oo. You can call it "market conformism" or even "market totalitari
anism". It's like betting on students for the next exam by allocat
ing the exact amount of how much each student got on the previous
exam.


However, as a tool, I think it's still very useful. Although I don
't believe it at all, I don't think that it is 100% false and give
s you no insight. At least diversifying actually works. If you don
't like it, then just use other tools.