# Modern Portfolio Theory And Index Funds

Summary of Modern Portfolio Theory: "Diversify".


Modern Portfolio Theory is all about maximizing the expected return
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
standard 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 portfolio.
Therefore linear combinations of the market portfolio (an idealized
index fund) and the risk-free asset (an idealized short-term
government bond) gives you the solution of these optimization
problems. Because you removed every unessential risk for any expected
return.

On the risk-return plane, the line made by those linear combinations
is called the capital market line. And it is the tangent line from
the 100% risk-free portfolio to the efficient frontier (the curve
that consists of risk-efficient portfolios without the risk-free
asset).


Long story short, Modern Portfolio Theory says that you should buy
just index funds and nothing more. You can explain it with Efficient
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
term, most investors (including professional fund managers) actually
cannot beat the market.

But like Nassim Taleb criticizes, the normal distribution assumption
is unreal and it is not immune to a black swan. As usual, historical
data is overrated in the theory. He recommends the barbell strategy
for a black swan instead. It is basically [90% doomsday prepper] &
[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
too. You can call it "market conformism" or even "market
totalitarianism". It's like betting on students for the next exam
by allocating 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
gives you no insight. At least diversifying actually works. If you
don't like it, then just use other tools.