April 30, 2017    12 minute read

Should Diversification be Primary Consideration in Asset Allocations?

Succumbing To Modern Portfolio Theory    April 30, 2017    12 minute read

Should Diversification be Primary Consideration in Asset Allocations?

Recently one of the most successful Wall Street investors Warren Buffet urged investors to forget about active investment and simply put their money into index funds. Contrary to his previous ideas that one should strive to make investment decisions based on the understanding of fundamentals, now he is of the view that it is better to embrace a passive approach and follow the index.

It seems that Buffet has succumbed to the popular view as presented by Modern Portfolio Theory (MPT) that financial asset markets always fully reflect all available and relevant information, and that 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 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 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 increase. 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 that methods which attempt to extract information from historical data, such as fundamental or technical analysis, are of little help. For whatever an analyst will uncover in the data is already known to the market and hence will not assist in “making money”.

According to one of the pioneers of MPT, Burton G. Malkiel,

The theory holds that the market appears to adjust so quickly to information about individual stocks and the economy as a whole that no technique of selecting a portfolio-neither technical nor fundamental analysis-can consistently outperform a strategy of simply buying and holding a diversified group of securities.

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.

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.

The basic idea of MPT is that a portfolio of volatile stocks, i.e. risky 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 total risk. MPT shows that if an investor wants to reduce investment risk he should practice diversification.

Does the MPT Framework Make Sense?

The major problem with 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 homogeneous expectations, then why should there be 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 a fall in the price. The MPT framework 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 intrinsic 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 it valid to argue that past and present information is imbedded in prices and therefore of no consequence?

It is questionable whether the duration and the strength of the effects of various causes can be discounted by the market participants.  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, will in fact set in motion the process of the boom-bust cycle.

We hold that neither the timing of the economic bust nor the length of an economic boom can be discounted as such by market participants. On the contrary, 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.

Also, various causes, once set in motion, initially only affect some individuals’ real income. As time goes by 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.

To suggest, then, that somehow the market will quickly incorporate all future changes of various present causes without telling us how it is done is questionable.  Even various econometric analyses indicate that the prices of financial assets tend to be driven by past information, such as past changes in the money supply growth rate.

It has to be realized that markets do not exist by themselves independently of individuals. Markets are comprised of individual investors who require time to understand the implications of various causes and their effects on the prices of financial assets.

Even if investors anticipated, a particular cause that still doesn’t mean that everybody understands the likely effect of this cause. In addition, 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 must know consumers’ preferences in advance but also how these preferences are going to change.

We have seen 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 will cancel each other out, thereby reducing 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.

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. This way of conducting business would not be an entrepreneurial investment but rather gambling.

Uncertainty Forces Active Rather Passive Investment Decisions

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,

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.

Now, profit emerges once an investor/ 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.

The recognition of the existence of potential profits means that the investor/ entrepreneur has particular knowledge that other people do not have.

This unique knowledge means that profits are not the outcome of random events, as 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. Planning and research however can never guarantee that profit will be secured. Various unforeseen events can upset investor/entrepreneurial forecasts.

Errors, which lead to losses in the market economy, are an essential part of the navigational tools that direct the process of allocation of resources in an uncertain environment in line with what consumers dictate.

Uncertainty is part of the human environment, and it forces individuals to adopt active positions, rather than resign to passivity, as implied by the MPT.

Investment Decisions Cannot Ignore Government and Central Bank Tampering

In a hampered environment investment decisions that ignore the actions of the government and the central bank are likely to generate losses. Even if an investor’s decisions were based on the correct assessments of the business, ignoring the actions of the government and the central bank could generate bad investment decisions.

On account of government and central bank policies, various projects are established that in the absence of government and central bank intervention would not be considered. Because these government and central bank supported activities are funded by means of diverting real wealth from wealth generators, this undermines the ability of wealth generators to generate that wealth.

Given that the effect of these policies is spread across the entire business environment it becomes much harder to identify wealth generators from non-wealth generators. This however, does not imply that an investor/businessman must stop trying to identify wealth generators versus non-wealth generators and resign to passivity.

On the contrary, he must try to ascertain the possible effect that a change in government and central bank policies is going to have on various businesses.

Contrary to the MPT, which recommends a passive approach in the investment process on account of uncertainty, it is necessary to reiterate that uncertainty is part of the human environment and it forces individuals to adopt active positions, rather than resign to passivity.

We suggest that MPT doesn’t deal with a real world businessman but with an imaginary construction. This construction fits very well the complex mathematics that MPT employs. Needless to say the assumption that all the known information is imbedded in asset prices and that profits are random is the key requirement of the MPT story. In this sense, the MPT is just another curve fitting exercise. MPT is based on assertions that cannot be logically defended.

We suggest that investors, in order to be successful, are required to ascertain what is going on in a given business environment i.e. to be active in their investment decisions. Failing to do so could be very costly.

John Maynard Keynes held 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.

By MPT it is futile to make sense of what is going on – everything is in a state of flux hence the best the investor can do is to diversify. Detailed investment or economic analysis, in this respect, is a waste of time.

Also, following MPT, if one wants to secure a 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.

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 doesn’t have a life of its own. The success or failure of investment in stocks depends ultimately on the same factors that the determine success or failure of any business. On this Mises said,

The success or failure of the investment in preferred stock, bonds, debentures, mortgages, and other loans depends ultimately also on the same factors that determine success or failure of the venture capital invested. There is no such thing as independence of the vicissitudes of the market.

Proponents of modern portfolio theory hold that diversification is the key for the risk minimization. We hold that the key should be evaluation of the profitability of various investments and not diversification as such. A portfolio of stocks of businesses which best meet consumer needs will outperform one which is diversified for the sake of diversification and which includes businesses which do not satisfy consumer wants as efficiently or effectively.

We suggest that MPT does not depict the essence of a businessman’s central task. The world that the MPT depicts has nothing to do with the real world in which we live.  MPT, by means of dubious assumptions, presents a caricature of an investor/ businessman who finds it futile to understand the business environment.

By Dr Frank Shostak 

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