Berkshire Hathaway Phenomenon In the Context of Modern Finance Theory
Berkshire Hathaway
Phenomenon
In the Context of Modern
Finance Theory
Septtember
2013
Berkshire Hathaway Phenomenon
In the Context of Modern Finance Theory
Introduction
Over the 46 years ending December 2012, Warren Buffett (Berkshire Hathaway) has achieved a compound, after-tax, rate of return in excess of 20% p.a. Such consistent, long term, out performance might be viewed as incompatible with modern finance theory.
This essay discusses the Berkshire Hathaway phenomenon in the context of modern finance theory. Part 1 Modern Portfolio Theory
Berkshire Hathaway’s investing strategies mainly differ with modern portfolio theory on two aspects. The first one is the attitude towards the undesirable thing in investment. And the second one is the perspective of diversification.
As Harry Markowitz pointed out in Portfolio Selection, one of the assumptions is (Markowitz,
1952)“the investor does (or should) consider expected return as a desirable thing and variance of return an undesirable thing”. However, in Warren Buffet’s point of view, (Roberg
G, 2005) the only undesirable thing should be the possibility of harm. He emphasizes on conducting fundamental analysis to work out a company’s future profits, so as to determine the intrinsic value instead of monitoring the stock prices. This is because in the long term, the investment outcome is mainly harmed by misjudging the business value, including misjudging of inflation rate and interest rate etc. As such, risk is defined differently between
Mr Buffett and Modern Portfolio Theory; one is defined by possibility of misjudging the
intrinsic value of business, the other being simplified to variance of expected returns. If we consider risk as a probability statement, then maybe Mr Buffett’s definition is closer to the original meaning.
Also, the assumption of maximising one-period expected utility is not what Buffet focuses on in his investment strategies.
(Roberg G, 2005)In
Phenomenon
In the Context of Modern
Finance Theory
Septtember
2013
Berkshire Hathaway Phenomenon
In the Context of Modern Finance Theory
Introduction
Over the 46 years ending December 2012, Warren Buffett (Berkshire Hathaway) has achieved a compound, after-tax, rate of return in excess of 20% p.a. Such consistent, long term, out performance might be viewed as incompatible with modern finance theory.
This essay discusses the Berkshire Hathaway phenomenon in the context of modern finance theory. Part 1 Modern Portfolio Theory
Berkshire Hathaway’s investing strategies mainly differ with modern portfolio theory on two aspects. The first one is the attitude towards the undesirable thing in investment. And the second one is the perspective of diversification.
As Harry Markowitz pointed out in Portfolio Selection, one of the assumptions is (Markowitz,
1952)“the investor does (or should) consider expected return as a desirable thing and variance of return an undesirable thing”. However, in Warren Buffet’s point of view, (Roberg
G, 2005) the only undesirable thing should be the possibility of harm. He emphasizes on conducting fundamental analysis to work out a company’s future profits, so as to determine the intrinsic value instead of monitoring the stock prices. This is because in the long term, the investment outcome is mainly harmed by misjudging the business value, including misjudging of inflation rate and interest rate etc. As such, risk is defined differently between
Mr Buffett and Modern Portfolio Theory; one is defined by possibility of misjudging the
intrinsic value of business, the other being simplified to variance of expected returns. If we consider risk as a probability statement, then maybe Mr Buffett’s definition is closer to the original meaning.
Also, the assumption of maximising one-period expected utility is not what Buffet focuses on in his investment strategies.
(Roberg G, 2005)In
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