Modern Portfolio Theory: Economics without Praxeology
A popular idea in finance theory is that the prices of financial assets fully reflect all available and relevant information and that adjustment to new information is virtually instantaneous. Modern portfolio theory (MPT) postulates that market participants are at least as good at price forecasting as any model that a financial market scholar can come up with, given the available information.1
In this way of thinking, asset prices respond only to the unexpected part of any information, since the expected part is already embedded in prices, so changes in asset prices occur because of news that cannot be predicted in a systematic manner. 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. A simple policy of random buying and holding will suffice, as asserted by one of the pioneers of the MPT, Burton G. Malkiel, in his famous book A Random Walk Down Wall Street.
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.”2
Proponents of MPT claim that attempts to extract information from historical data, such as fundamental or technical analysis, are of little help because anything an analyst uncovers in the data is already known to the market and hence is not going to assist in “making money.”
MPT Claims Diversification Reduces Risk
A security expected to generate returns that are not expected to deviate significantly from the historical average is termed by the MPT as a low risk, while a security that generates returns that are volatile from year to year is regarded as risky. The MPT assumes that investors are risk averse and want high guaranteed returns. According to the MPT, if an investor wants to reduce investment risk, he should practice diversification.
The basic idea of MPT is that volatile stocks (i.e., risky stocks) can be combined into a portfolio and this will lead to the reduction of overall risk. The guiding principle for combining stocks is that each stock represents activities 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 labeled systematic risk; the second part, unsystematic. According to the MPT, through diversification, only unsystematic risk can be removed. Systematic risk cannot be removed through diversification. Consequently, it is held that returns on any stock or portfolio will be always 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 are more sensitive to market movements, while other stocks display less sensitivity. The relative sensitivity to market moves is estimated by means of statistical methods that establish a beta, which 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 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.
Does the MPT Framework Make Sense?
The major problem with the MPT is that it assumes that all market
Article from Mises Wire