By Dr Frank Shostak
According to Modern Portfolio Theory (MPT), financial asset prices reflect all available and relevant information, and that any adjustment to new information is virtually instantaneous. On this way of thinking, asset prices respond only to the unexpected part of any information, since the expected part is already embedded in prices.
For instance, if the central bank raises interest rates by 0.5 percent, and if market participants anticipate this action, asset prices will reflect this expected increase prior to the central bank raising interest rates. Once the central bank lifts the interest rate by 0.5 percent this increase will have no effect on asset prices since it is already imbedded in asset prices.
Should, however, the central bank raise interest rates by 1 percent, rather than the 0.5 percent expected by market participants, then the prices of financial assets will react to this additional increase.
According to the 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 that methods, which attempt to extract information from historical data, such as fundamental analysis or technical analysis, are of little help. For whatever an analyst will uncover in the data is already known to the market and will not assist in “making money”.
Hence, a simple policy of random buying and holding will do the trick. According to Burton G. Malkiel,
A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by the expert.
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.
Following the MPT, since the future direction of the stock market cannot be known then 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 as a low risk. A security whose returns are volatile from year to year is regarded as risky.
The MPT assumes that investors are risk averse and they want high guaranteed returns. To comply with this assumption, the MPT instructs investors on how to combine stocks in their portfolios to give them the least possible risk consistent with the return they seek. The MPT shows that if an investor wants to reduce investment risk, he should practice diversification.
According to the MPT, a portfolio of volatile stocks can be combined together and that this in turn will lead to a reduction of the overall risk of the portfolio. The guiding principle for combining stocks is that each stock represents activities that are affected by given factors differently. Once combined, these differences will cancel each other out, thereby reducing the total risk, so it is held.
Systematic versus unsystematic risk
According to the 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 the risk results from factors peculiar to a particular stock. The first part of the risk is labelled systematic risk, the second part, unsystematic.
Following the MPT, through the diversification, only unsystematic risk is eliminated. Systematic risk cannot be removed through the diversification. Consequently, it is held that return on any stock or portfolio is always related to the systematic risk, i.e. the higher the systematic risk, the higher the return.
The systematic risk of stocks captures the reaction 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 by means of statistical methods and is known as beta. (Beta is the numerical description of systematic risk). If a stock has a beta of 2 it means that 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. If, however, the stock has a beta of 0.5 then it tends to be more stable than the market.
Does the MPT Framework Make Sense?
According to the MPT framework, all market participants have the same expectations about future securities’ returns. Yet, if participants are alike in the sense of having homogeneous expectations, then why should there be trade?
After all, trade implies the existence of heterogeneous expectations. A buyer expects a rise in the asset price while the seller expects a fall in the price.
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.
Now, if on average, everybody knows the true value then no one will need to learn from past errors. Given that by the MPT these errors are random it follows that any learning will be futile.
Are past and present information already in prices?
Is it valid that the past and the present information is imbedded in prices and therefore of no consequence in the forecast of asset prices?
For instance, a market-anticipated lowering of interest rates by the central bank, while being regarded as old news and therefore not supposed to have effects, will in fact set in motion the process of the boom-bust cycle.
Furthermore, it is questionable that the timing of the economic bust can be discounted by market participants. What typifies an economic bust is that before it emerges most investors tend to be optimistic about the business environment – the bust catches them by surprise.
Also, various causes, once set in motion, initially only affect some individuals’ income. As time goes by however, the effect of these causes spreads across a wider spectrum of individuals. Obviously, these changes in the incomes of individuals generate changes in the relative prices of assets. To suggest, then, that somehow the market will quickly incorporate all the future changes on account of various present causes without telling us how it is done does not seem to us credible.
Again, the guiding principle of the MPT for combining stocks is that each stock represents activities that are affected by given factors differently. Once combined, these differences will cancel each other out, thereby reducing risk.
However, during a large financial crisis, various asset prices that normally have an inverse correlation with each other become positively correlated and fall together. Furthermore, in an attempt to minimize risk, practitioners of the 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 it fundamentals. This could raise the likelihood of putting too much money in bad investments.
The MPT framework gives the impression that the stock market can exist separately from the real world. However, the stock market does not have a life of its own. That is why an investment in stocks should be regarded as an investment in business as such.
Should investor focus on risk rather than profit opportunities?
Given that securing profit in the MPT framework is dominated by random factors, the emphasis in the investment decision of this framework is on diversification in order to minimize risk.
We suggest that an investor who is preoccupied with risk rather than identifying profit opportunities is likely to undermine himself. On this Mises wrote,
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.
John Maynard Keynes held a similar view. On August 15th, 1934, Keynes wrote to Francis Scott, the Provincial Insurance chairman,
As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little.
Summary and Conclusion
The proponents of the modern portfolio theory (MPT) hold that diversification is the heart of investment. We hold that the key should be the evaluation of the profitability of various investments and not the diversification as such. Also, following the MPT, if one wants to secure higher profit one needs to take a greater risk. We suggest that the extent of an entrepreneur’s return on his investment is determined not by how much risk he assumes, but rather whether he complies with consumers’ wishes.
