Excess Returns · Tuesday, July 28, 2026
Robert Hagstrom argues that modern portfolio theory's definition of risk as variance is flawed, contrasting it with Warren Buffett's view that permanent loss of capital is the true risk. He notes that academic theories often overlook the underlying business fundamentals.
“Well, where are we now? Is we're still plus 90% of active managers underperforming. We're still swimming in a sea of people who think, you know, okay, volatility isn't risk. Permit loss of capital is risk.”
“Markowitz, a Nobel Prize for defining risk is variance. And Buffett comes out and says, fearing that kind of volatility can lead you to do very, very risky things.”
“I think, um, what we wrote in the book, and, um, this comes from Peter Bernstein's book, Capital Ideas, so let me give credit where credit was due, which is great book and, uh, Capital Ideas goes through the advent of, of modern portfolio theory and things of that nature.”
“And so he came up with this theory, just out of the blue. I mean, it's, you know, there's no source, no, you know, somebody said this, I'm quoting this and then he just, kind of dreamt it up.”
“And, uh, and of course, you know, in the 1950s, you know, sitting in Chicago, uh, you know, right that that he wrote this paper and it wasn't, it wasn't a very long paper. I think about 14 pages. It was quite unremarkable in the amount of words that he used, a lot of graphs and stuff of that nature. But, you know, he plucked out of the solar system out there and says, you know, I think, you know, people don't like variance, they don't like bounces. And so, you know, I think I will, I will define risk as the variance of return.”
“He didn't cite what Ben Graham said, that risk was a margin of safety question. It wasn't, nobody was saying it was variance. He just decided that he was going to take it upon himself to say that risk was variance.”
“This is why we're reviewing this book. If you haven't. This is timeless stuff. Let's go straight into the deep end on Markowitz. A Nobel Prize for defining risk is variance. And Buffett comes out and says, fearing that kind of volatility can lead you to do very, very risky things. Yeah. Who's right? Who's right?”