Diversification versus risk

By Dr Frank Shostak

By a popular way of thinking, the prices of financial assets fully reflect all available and relevant information. In addition, adjustment to new information is virtually instantaneous. This way of thinking is closely linked with the modern portfolio theory (MPT), which postulates that market participants are at least as good at price forecasting as is any model that a financial market scholar can come up with, given the available information.  

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. 

It is held that changes in asset prices occur because of news, which cannot be predicted in any systematic manner. The proponents of the MPT argue that if past data contains no information for the prediction of future prices, then it follows that there is no point in paying attention to fundamental analysis. A simple policy of random buying and holding will do the trick as asserted by one of the pioneers of the MPT, Burton G. Malkiel, in his famous book “A Random Walk Down Wall Street”

Malkiel also suggests that,

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.

Again, according to MPT, methods that attempt to extract information from historical data, such as fundamental or technical analysis, are of little help. For whatever an analyst is going to uncover in the data is already known to the market and hence is not going to assist in “making money”. 

MPT indicates diversification reduces investment risk

A security that is expected to generate returns that are not expected to deviate significantly from its historical average is termed by the MPT as a low risk. A security that generates returns that are volatile from year to year is regarded as risky. The MPT assumes that investors are risk averse and they want high guaranteed returns. According to the MPT, if an investor wants to reduce investment risk he should practice diversification. 

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

The theory indicates that 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 company. The first part of the risk is labelled systematic risk, the second part, unsystematic. According to the MPT through diversification, only unsystematic risk can be removed. Systematic risk cannot be removed through diversification. Consequently it is held that return on any stock or portfolio will be always positively 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 moves 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% the stock tends to rise by 20%. 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?

The major problem with the MPT is that it assumes that all market participants have the same expectations about future securities returns. Yet, if participants are alike in the sense of having similar expectations, then why should there be trade? After all, trade implies the existence of different expectations. This is what bulls and bears are all about. A buyer expects a rise in the asset price while a seller expects a fall in the price. 

Even if we were to accept that modern technology enables all market participants equal access to news, there is still the issue of news interpretations. By the MPT framework 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, implying that profits or losses are random phenomena. 

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. Yet, if every individual has different knowledge, then this difference will have an effect on his forecast. A success or a failure in predicting asset prices will not be completely random, as the MPT suggests, but must also be attributed to each individual’s knowledge. 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

The stock market does not have a life of its own

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, and not just as an investment in stocks. On this Rothbard says in “America’s Great Depression” p.79 “that the stock market tends to reflect the “real” developments in the business world”

By becoming an investor in a business, an individual has engaged in an entrepreneurial activity. He has committed his capital with a view to supply the most urgent needs of consumers. For an entrepreneur the ultimate criteria for investing his capital is to employ it in those activities which will produce goods and services that are on the highest priority list of consumers. It is this striving to satisfy the most urgent needs of consumers that produces profits, and it is this alone that guides entrepreneurs.

Is it valid to argue that past information is completely imbedded in prices and therefore of no consequence? It is questionable whether the market participants can discount the duration and the strength of effects of various causes. For instance, according to the MPT a market-anticipated lowering of interest rates by the Central Bank whilst seen as old news and not supposed to have real effects, is going to set in motion the process of the boom-bust cycle. In addition, various causes once set in motion, initially only affect some individuals’ real income. As time goes by the effects of these causes spreads across a wider spectrum of individuals. 

Obviously, these changes in the real incomes of individuals is likely to produce changes in the relative prices of assets. To suggest, then, that somehow the market will quickly incorporate all future changes because of various present causes without telling us how it is going to be done is questionable. It has to be realized that markets are comprised of individual investors who require time to understand the implications of various causes and their implications on the prices of financial assets. 

Even if a particular cause was anticipated by the market that does not mean it was understood correctly and therefore discounted. It is hard to imagine that the effect of a particular cause, which begins with a few individuals and then spreads over time across many individuals, can be assessed and understood instantaneously. 

For this to be so, it would mean that market participants could immediately assess future consumers’ responses and counter responses to a given cause. This, of course, must mean that market participants not only have the information regarding consumers’ preferences but also the information how these preferences are going to change. Note though, consumer preferences cannot be revealed before consumers have acted.

Are Profits Random Phenomena?

The proponents of the MPT claim that the main message of their framework is that excessive profits cannot be secured out of public information. They maintain that any successful method of making profits must ultimately be self-defeating. 

Now, it is true that profits as such can never be a sustainable phenomenon. However, the reasons for this are not those presented by the MPT. Profit emerges once an entrepreneur discovers that the prices of certain factors are undervalued relative to the potential value of the products that these factors, once employed, could produce. By recognizing the discrepancy and doing something about it, an entrepreneur removes the discrepancy, i.e., eliminates the potential for a further profit. According to MurrayN. Rothbard,

Every entrepreneur, therefore, invests in a process because he expects to make a profit, i.e., because he believes that the market has under-priced and undercapitalized the factors in relation to their future rents.

The recognition of the existence of potential profits means that an entrepreneur had particular knowledge that other people did not have. This unique knowledge means that profits are not the outcome of random events, as the MPT suggests. For an entrepreneur to make profits, he must engage in planning and anticipate consumer preferences. Consequently, those entrepreneurs who excel in their forecasting of consumers’ future preferences will make profits.

Profits not risks drive entrepreneurs

In the words of Ludwig von Mises, 

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.

In an attempt to minimize risk, practitioners of the MPT tend to pursue a high degree of diversification. However, having a large number of stocks in a portfolio might leave little time to analyse the stocks and understand it fundamentals. This could raise the likelihood of putting too much money in bad investments. This way of conducting business would not be an entrepreneurial investment but rather gambling. 

Note that the guiding principle of MPT for combining stocks is that 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 portfolio risk. However, it does not necessary always works this way. During a large financial crisis, various asset prices that normally have an inverse correlation with each other become positively correlated and fall together. 

Also, Keynes had misgivings about the portfolio diversification to reduce risk. On August 15, 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.  

Conclusion   

The Modern Portfolio Theory (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. Proponents of the MPT argue that diversification is the key to the creation of the best possible consistent returns. We suggest that the key should be 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 size 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.