Modern Portfolio Theory Is Mistaken: Diversification Is Not Investment

According to modern portfolio theory (MPT), financial asset prices always fully reflect all available and relevant information, and any adjustment to new information is virtually instantaneous. Thus, asset prices respond only to the unexpected part of information since the expected portion is already embedded in prices.

For example, if the central bank raises interest rates by 0.5 percent, and if market participants anticipated this action, asset prices will reflect this expected increase prior to the central bank’s raising interest rates. Note that once the central bank lifts the interest rate by 0.5 percent, this increase will have no effect on asset prices since stock prices have already adjusted. However, should the central bank raise interest rates by 1 percent, rather than the 0.5 percent expected by market participants, then asset prices will react to this news.

According to MPT, the individual investor cannot outsmart the market by trading based on the available information since the available information is already contained in asset prices. This means methods that attempt to extract information from historical data, such as fundamental analysis or technical analysis, are of little help. Whatever an analyst will uncover in the data is already known to the market and hence will not assist in “making money.”

By this logic, stock market prices move in response to new, unexpected information. Since by definition the unexpected cannot be known, it implies that an individual’s chances of anticipating the general direction of the market are as good as anyone else’s chances.

Because the future direction of the stock market cannot be known, the only way of earning above-average returns is to assume greater risk. A security whose returns are not expected to deviate significantly from its historical average is termed low risk. A security whose returns are volatile from year to year is regarded as risky.

MPT assumes that investors are risk averse and want high, guaranteed returns. To comply with this assumption, MPT instructs investors on how to combine stocks in their portfolios, giving them the least possible risk consistent with the return they seek by practicing diversification.

According to MPT, a portfolio of volatile stocks can be combined and this, in turn, will lead to a reduction of the overall risk of the portfolio. The guiding principle for combining stocks is this: Each stock represents activities that are affected by given factors differently. Once combined, these differences are expected to cancel each other out, thereby reducing the total risk.

Systematic versus Unsystematic Risk

According to MPT, risk can be broken into two parts. The first part is associated with the tendency of returns on a stock to move in the same direction as the general market. The other part of risk results from factors peculiar to a particular company. The first part is labeled systematic risk, the second part, unsystematic.

Following MPT through diversification, only unsystematic risk is eliminated. Systematic risk cannot be removed through diversification. Consequently, it is held that return on any stock or portfolio will always be related to the systematic risk, so the higher the systematic risk, the higher the return.

The systematic risk of stocks captures the response of individual stocks to general market movements. Some stocks tend to be more sensitive to market movements while other stocks display less sensitivity.

The relative sensitivity to market movements is estimated via statistical methods and is known as beta. (Beta is the numerical description of systematic risk.) If a stock has a beta of two, on average it swings twice as much as the market. If the market goes up by 10 percent, the stock tends to rise by 20 percent. However, if the stock has a beta of 0.5, it tends to be more stable than the market.

Does the MPT Framework Make Sense?

The major problem with the MPT framework is that it is based upon the assumption that all market participants have the same expectations about future securities’ returns. Yet, if participants have homogeneous expectations, why would anyone trade? After all, trade implies the existence of heterogeneous expectations. This is what bulls and bears are all about. A buyer expects a rise in the asset price while the seller expects the price to fall.

The MPT framework also implies that market participants have the same knowledge. Forecasts of asset prices by market participants are clustered around the true value, with deviations from the true value randomly distributed.

It also means that since, on average, everybody knows the true underlying value, then no one will need to learn from past errors since these errors are random and therefore any learning will be futile. In the words of Hans-Hermann Hoppe, “If everyone’s knowledge were identical to everyone else’s, no one would have to communicate at all. That men do communicate demonstrates that they must assume that their knowledge is not identical.”

Is Past and Present Information Already in Prices?

Is it valid to argue that past and present information is imbedded in prices and therefore of no consequence in the forecast of asset prices? For example, a market-anticipated lowering of interest rates by the central bank, while being regarded as old news and therefore not supposed to have real effects, will in fact set the boom-bust cycle in motion.

The timing of the economic bust cannot be discounted by market participants. For instance, what typifies an economic bust is that before it starts, most investors tend to be very optimistic about the business environment—the bust catches them by surprise.

Once the causes of an economic bust are set in motion, only some individuals see changes in their real income. Over time, however, the effect of these causes spreads across a wider spectrum of individuals. Obviously, these changes in the real incomes of individuals generate changes in the relative prices of assets, so to suggest that the market will quickly incorporate all the future changes of various present causes without telling us how it is done is questionable.

Furthermore, in an attempt to minimize risk, practitioners of MPT tend to institute a high degree of diversification. Having a large number of stocks in a portfolio might leave little time to analyze the stocks and understand their fundamentals. This could raise the likelihood of putting too much money in bad investments.

Should Investors Focus on Risk Rather Than Profit Opportunities?

An investor who is preoccupied with risk rather than identifying profit opportunities is likely to undermine himself. Ludwig von Mises wrote,

There is no such thing as a safe investment. If capitalists were to behave in the way the risk fable describes and were to strive after what they consider to be the safest investment, their conduct would render this line of investment unsafe and they would certainly lose their input. . . . The owner of capital does not choose between more risky, less risky and safe investments. He is forced, by the very operation of the market economy, to invest his funds in such a way as to supply the most urgent needs of the consumers to the best possible extent. A capitalist never chooses that investment in which, according to his understanding of the future, the danger of losing his input is smallest. He chooses that investment in which he expects to make the highest possible profits.

Summary and Conclusion

MPT gives the impression that there is a difference between investing in the stock market and investing in a business. However, the stock market does not have a life of its own. The success or failure of investment in stocks depends ultimately on the same factors that determine success or failure of any business.

The proponents of modern portfolio theory hold that diversification is the heart of investment. Instead, the key should be the profitability of investments, not their diversification.

Courtesy of Mises.org

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