Diversification versus Risk
It is widely held that financial asset prices fully reflect all available and relevant information, and that adjustments to new information is virtually instantaneous. This way of thinking which is known as the Efficient Market Hypothesis (EMH) is closely linked with the modern portfolio theory (MPT), which 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
It is held that 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.” Changes in asset prices occur because of news, which cannot be predicted in any 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 do the trick 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
MPT Indicates Diversification Reduces Investment Risk
A security whose returns are not expected to deviate significantly from its historical average is termed by MPT as low risk. A security whose returns are volatile from year to year is regarded as risky. MPT assumes that investors are risk averse and they want high guaranteed returns. To comply with this assumption the MPT instructs investors how to combine stocks in their portfolios to give them the least possible risk consistent with the return they seek. MPT shows that if an investor wants to reduce investment risk, he should practice diversification.
The basic idea of MPT is that a portfolio of volatile stocks (i.e. risky stocks) can be combined together and this in turn will lead to a reduction in overall risk. 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 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 MPT, through diversification only unsystematic risk is eliminated. Systematic risk cannot be removed through diversification. Consequently, it is held that the return on any stock or portfolio will be always 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 moves is estimated by means of statistical methods and is known as beta. (Beta is the num
Article from Mises Wire