According to the Modern Portfolio Theory (MPT), financial asset prices fully reflect all available and relevant information, and that any adjustment to new information is virtually instantaneous. For instance, 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 raising interest rates. Note that, by the MPT, 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 embedded in prices.
Now, if the central bank lifts 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, an 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 the historical data, such as the fundamental analysis or the technical analysis, are of little help. Whatever an analyst will discover in the data is already known to the market, and hence, will not assist in “making money.”
Now, according to the MPT, changes in asset prices occur because of news, which cannot be predicted in any systematic manner. Again, the proponents of the MPT hold that, if the past data contains no information for the prediction of future prices, then it follows that there is no point in paying attention to the fundamental and technical analyses. According to 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.”
Does the MPT framework make sense?
Is it valid to hold that past information is completely embedded in prices and therefore of no consequence? It is questionable whether market participants can discount the duration and the strength of the effects of various causes. 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 real effects—is in fact going to set in motion the process of the boom-bust cycle.
It is quite likely that changes in the real incomes of individuals on account of the boom-bust cycle will result in changes in the relative prices of assets. To suggest, then, that somehow the market will quickly incorporate all the future changes as a result of various present causes without telling us how it is done is questionable. Even if we were to accept that modern technology enables market participants an equal access to news, there is still the issue of interpreting the news. It has to be realized that markets are comprised of individual investors who require time to understand the implications of various causes on the prices of financial assets.
Even if a particular cause was anticipated by the market, that does not mean that its effects were understood and discounted. For this to be so, it would mean that the market participants could immediately assess the future consumers’ responses and counter-responses to a given cause. This, of course, means that the market participants not only must know consumers’ preferences but also how these preferences will change.
Diversification and Investment Risk
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 reduce 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 will 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 overall market. The other part of the risk is on account of factors peculiar to a particular stock. The first part of the risk is labeled as systematic risk; the second part is labeled as unsystematic risk. According to the MPT, through diversification, only unsystematic risk can be removed. Systematic risk, however, cannot be removed through diversification. It is held that a return on any stock or a portfolio is positively correlated with the systematic risk (i.e. the higher the systematic risk the higher the return).
The systematic risk captures the response of individual stocks to the overall 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 the 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.
Are profits the reward for risk taking?
Should one regard profit as a reward for risk taking? In the words of Ludwig von Mises,
A popular fallacy considers entrepreneurial profit a reward for risk taking. It looks upon the entrepreneur as a gambler who invests in a lottery after having weighed the favorable chances of winning a prize against the unfavorable chances of losing his stake. This opinion manifests itself most clearly in the description of stock exchange transactions as a sort of gambling.
Mises then suggests,
Every word in this reasoning is false. 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.
Mises then adds,
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.
Moreover, according to Mises,
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.
Again, for a businessman, 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, thereby making a profit. It is this striving to satisfy the most urgent needs of consumers that produces profits. Hence, an entrepreneur’s return on his investment is determined not by how much risk he assumes, but rather whether he complies with consumers’ wishes.
In an attempt to minimize risk, practitioners of the MPT tend to institute a high degree of diversification. However, having a large number of stocks in a portfolio might leave little time to analyze the stocks and understand their fundamentals. This could increase the likelihood of putting too much money in bad investments. This way of conducting business would not be an entrepreneurial investment but rather gambling.
John Maynard Keynes had also misgivings about diversification in order 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 success or failure of investing in stocks depends ultimately on the same factors that determine the success or a failure of any business. Proponents of the MPT are of the view that diversification is the key for the generation of the best possible consistent returns. The key is the profitability of various investments and not the diversification as such. Furthermore, following MPT, if one wants to secure higher profits, one needs to take greater risk. Contrary to this way of thinking, the entrepreneur’s return on his investment is determined not by how much risk he assumes, but rather whether he complies with consumers’ wishes.
