164 THE WARREN BUFFETT WAY
of concepts that is collectively known as modern portfolio theory.Be-
cause this is a book about Buffett’s thinking, and because Buffett him-
self does not subscribe to this theory, we will not spend much time
describing it. But as you continue to learn about investing, you will
hear about this theory, and so it is important to cover its basic elements.
Then we’ll give Buffett a chance to weigh in on each.
Modern portfolio theory is a combination of three seminal ideas
about f inance from three powerful minds. Harry Markowitz, a graduate
student in economics at the University of Chicago, f irst quantif ied the
relationship between return and risk. Using a mathematical tool called
covariance, he measured the combined movement of a group of stocks,
and used that to determine the riskiness of an entire portfolio.
Markowitz concluded that investment risk is not a function of how
much the price of any individual stock changes, but how much a group
of stocks changes in the same direction. If they do so, there is a good
chance that economic shifts will drive them all down at the same time.
The only reasonable protection, he said, was diversif ication.
About ten years later, another graduate student, Bill Sharpe from
the University of California-Los Angeles, developed a mathematical
process for measuring volatility that simplif ied Markowitz’s approach.
He called it the Capital Asset Pricing Model.
So in the space of one decade, two academicians had def ined two
important elements of what we would later come to call modern port-
folio theory: Markowitz with his idea that the proper reward/risk bal-
ance depends on diversif ication, and Sharpe with his def inition of
risk. A third piece—the eff icient market theory ( EMT)—came from
a young assistant professor of f inance at the University of Chicago,
Eugene Fama.
Fama began studying the changes in stock prices in the early 1960s.
An intense reader, he absorbed all the written work on stock market be-
havior then available and concluded that stock prices are not predictable
because the market is too eff icient. In an eff icient market, as informa-
tion becomes available, a great many smart people aggressively apply that
information in a way that causes prices to adjust instantaneously, before
anyone can prof it. At any given moment, stock prices ref lect all available
information. Predictions about the future therefore have no place in an
eff icient market, because the share prices adjust too quickly.