By Frank Shostak *
According to modern portfolio theory (MPT), the prices of financial assets fully reflect all available and relevant information, and any adjustment to new information is virtually instantaneous.
For example, if the central bank raises interest rates by 0.5% and if market participants anticipated this action, asset prices will reflect this projected increase before the central bank raises interest rates. Note that once the central bank raises the interest rate by 0.5%, this increase will have no effect on asset prices, as it is already incorporated into asset prices.
However, if the central bank raised interest rates by 1%, instead of the 0.5% expected by market participants, financial asset prices would react to this further increase.
According to the MPT, the investor cannot outperform the market by trading based on the information available, as the information available is already in the asset prices. Changes in asset prices occur due to news, which cannot be predicted systematically.
This means that methods that attempt to extract information from historical data, such as fundamental analysis or technical analysis, are of little help, as what an analyst discovers in the data is already known to the market and therefore will not help. ” to earn money. “
Proponents of the MPT argue that if past data does not contain information for predicting future prices, it follows that it makes no sense to pay 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 the financial pages of a newspaper could select a portfolio that would work just as well as one carefully selected by the expert.
Does the MPT framework make sense?
Is it valid to argue that information from the past is completely embedded in prices and therefore has no consequences? It is questionable whether market participants can discount the duration and strength of various phenomena.
For example, an anticipated reduction in the interest rate market by the central bank, although considered old news, which is therefore not supposed to have any real effects, will set in motion the boom-bust cycle.
Viously, obviously, these changes in people’s real incomes 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 accept that modern technology allows all market participants to have equal access to news, there is still the issue of news interpretation. It should be noted that markets are made up of individual investors who need time to understand the implications of various causes and their implications on the prices of financial assets.
Even if the market anticipated a particular cause, this does not mean that it was understood and therefore discounted. If so, it would mean that market participants could immediately assess the responses and responses of future consumers to a given cause. This, of course, must mean that market participants not only need to know consumer preferences, but also how those preferences will change. However, consumer preferences cannot be disclosed before consumers have acted.
MPT involves diversification that reduces investment risk
The basic idea of MPT is that compiling a portfolio of volatile stocks, i.e. risk 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 certain factors differently. Once combined, these differences will cancel each other out, thus reducing the overall risk.
The theory indicates that the risk can be divided into two parts. The first part is associated with the tendency of the returns of a stock to move in the same direction as the general market. The other part of the risk is the result of factors specific to a specific company.
The first part of the risk is called systematic risk, the second part is not systematic. According to MPT, diversification only eliminates non-systematic risk. Systematic risk cannot be eliminated through diversification. The return on any stock or portfolio is considered to be positively related to the systematic risk, ie the higher the systematic risk, the higher the return.
Systematic stock risk captures the reaction of individual stocks to general market movements. Some stocks tend to be more sensitive to market movements, while other stocks show less sensitivity.
Sensitivity relative to market movements is estimated using 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 fluctuates twice as much as the market. If the market goes up 10 percent, stocks tend to rise 20 percent. However, if the stock has a beta of 0.5, it tends to be more stable than the market.
Are the benefits a reward for taking risks?
Is it true that profit is a reward for taking risks? In the words of Ludwig von Mises,
A popular fallacy considers business profit to be a reward for risk-taking. The employer is seen as a player who invests in a lottery after weighing the favorable chances of winning a prize against the unfavorable chances of losing their stake. This view is most clearly expressed in the description of stock exchange transactions as a kind of gambling.
Mises then suggests:
All the words in this reasoning are false. The owner of the capital does not choose between riskier, less risky and safe investments. The very functioning of the market economy forces him to invest his funds so that he can meet the most urgent needs of consumers as much as possible.
A capitalist never chooses that investment in which, according to his understanding of the future, the danger of losing his contribution is the least. Choose the investment in which you hope to make the most profits
It is likely that an investor who is concerned about risk rather than identifying profit opportunities will harm himself. On this he wrote Mises,
There is no safe investment. If capitalists behaved in the way described in the fable of risk and strove to achieve what they consider the safest investment, their conduct would make this line of investment unsafe and they would certainly lose their contribution.
Again, for a businessman the ultimate criterion for investing his capital is to use it in those activities that produce goods and services that are on the list of consumers with the highest priority. It is this effort to meet the most urgent needs of consumers that produces benefits. The size of the return on investment of the employer is not determined by the amount of risk it assumes, but by whether it meets the wishes of consumers.
In an attempt to minimize risk, MPT professionals tend to establish a high degree of diversification. However, having a large number of stocks in a portfolio can leave little time to analyze stocks and understand their fundamentals. This could increase the likelihood of investing too much money in bad investments. This way of doing business would not be a business investment, but rather a game of chance.
John Maynard Keynes also had doubts about diversification to reduce risk. On August 15, 1934, Keynes wrote to Francis Scott, the president of provincial insurance:
As time goes on, I am increasingly convinced that the right method of investing is to contribute fairly large sums to companies of which you are believed to know something and in the management of which you believe thoroughly. It is a mistake to think that the risk is limited by spreading too much among companies of which little is known
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 stock investing ultimately depends on the same factors that determine the success or failure of any business. Proponents of the MPT argue that diversification is the key to creating the best possible returns. The key should be the return on the various investments and not diversification as such. Also, after MPT, if you want to get higher profits, you need to risk more. In fact, the size of the return on your investment by an entrepreneur is not determined by the amount of risk you take, but by whether it meets the wishes of consumers.
- 1. Ludwig von Mises, Human Action: A Treatise on Economics, ed. Academic (Auburn, AL: Ludwig von Mises Institute, 1998), p. 805
- 2. Masses, human action, p. 805.
- 3. Masses, human action, p. 806.
- 4. Masses, human action, p. 806.
- 5. Quoted from David Chambers and Elroy Dimson, “Keynes the Stock Market Investor” (unpublished manuscript, March 5, 2012), PDF.
* About the author: Frank Shostak’s consultant, Applied Austrian School Economics, offers in-depth assessments of the financial markets and world economies. Contact email address.
Source: This article was published by the MISES Institute