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.
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.1
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.2
Is it valid to argue that past and present information is imbedded in prices and therefore of no consequence?
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.
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.
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.3
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.
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.4
Also, following MPT, if one wants to secure a higher profit one needs to take a greater risk. 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. 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.
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. 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.
- 1Burton G. Malkiel, A Random Walk Down Wall Street (New York: WW Norton,1985), p. 194.
- 2Hans-Hermann Hoppe, “On Certainty and Uncertainty, or: How Rational Can Our Expectations Be?” Review €if Austrian Economics 1O, no. 1 (1997): 49-78.
- 3Mises, Human Action, pp. 809-10.
- 4KEYNES THE STOCK MARKET INVESTOR‡ David Chambers a , Elroy Dimson a,b,∗ a Cambridge Judge Business School, Trumpington Street, Cambridge CB2 1AG, United Kingdom. b London Business School, Regents Park, London NW1 4SA, United Kingdom 5 March, 2012.
