According to modern portfolio theory (MPT), financial asset prices fully reflect all available and relevant information, and 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 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 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. Changes in asset prices occur because of news, which cannot be predicted in any systematic manner.
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 uncovers in the data is already known to the market and hence will not assist in “making money.”
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. According to one of the pioneers of MPT, Burton G. Malkiel, in his book A Random Walk Down Wall Street,
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 argue 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 various phenomena.
For instance, a market-anticipated lowering of interest rates by the central bank, while being regarded as old news, which is therefore not supposed to have real effects, will in fact set in motion the the boom-bust cycle.
Obviously, these changes in the real incomes of individuals will lead to changes in the relative prices of assets. To suggest, then, that somehow the market will quickly incorporate all the future effects of various present occurrences without telling us how it is done is questionable.
Even if we were to accept that modern technology enables all market participants to have equal access to news, there is still the issue of news interpretation. 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 for the prices of financial assets.
Even if a particular cause was anticipated by the market, that does not mean it was understood and therefore discounted. If this were so, it would mean that market participants could immediately assess future consumers' responses and counterresponses to a given cause. This, of course, must mean that market participants not only must know consumers' preferences but also how these preferences are going to change. Consumer preferences, however, cannot be revealed before consumers have acted.
MPT Implies Diversification Reduces Investment Risk
The basic idea of MPT is that compiling a portfolio of volatile stocks, i.e., risky stocks, will lead to a reduction in overall risk. The guiding principle for combining stocks in this way 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 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 MPT, through diversification only unsystematic risk is eliminated. Systematic risk cannot be removed through diversification. It is held that return on any stock or portfolio is 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 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 10 percent, the stock tends to rise 20 percent. If however, the stock has a beta of 0.5, then it tends to be more stable than the market.
Are Profits Reward for Risk Taking?
Is it true that profit is a reward for risk taking? No. 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.
An investor who is preoccupied with risk rather than identifying profit opportunities is likely to undermine himself. On this 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.
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. It is this striving to satisfy the most urgent needs of consumers that produces profits. The size of an entrepreneur's return on his investment is determined not by how much risk he assumes, but rather by whether he complies with consumers' wishes.
In an attempt to minimize risk, practitioners of 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 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.
John Maynard Keynes also had misgivings about 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
Modern portfolio theory (MPT) gives the impression that there is a difference between investing in the stock market and investing in a business. The success or failure of investing in stocks depends ultimately on the same factors that determine the 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. The key should be the profitability of the various investments and not the diversification as such. In addition, following the MPT, if one wants to secure higher profit, one needs to take a greater risk. In fact, the size of an entrepreneur's return on his investment is determined not by how much risk he assumes, but rather by whether he complies with consumers' wishes.
