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Diversification: An Austrian View

Mises Daily: Wednesday, November 01, 2000 by

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According to the efficient markets hypothesis, 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.

It is thus suggested that since the future direction of the stock market cannot be known and that the only way of earning above average returns is to assume greater risk. This is described by the modern portfolio theory (MPT). It is accepted by the practitioners of this theory that risk is associated with the degree of dispersion of returns around the average of returns.

A security whose returns are not expected to deviate significantly from its historical average is termed as a 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.

Consider the following simple example:


Activity A
Activity B
Cold Weather
20%
-10%
Warm weather
-10%
20%

Let us assume that on average, half of the time the weather is cold and half of the time it is warm. According to the table, investment in activity A will yield a 20% return in cold weather and in warm weather will produce a loss of 10%. On average the return by investing in A will be 5%. The same outcome will be obtained with regard to investment in activity B.

The MPT then suggests that if the investor diversifies and invests one dollar in A and one dollar in B then he will be guaranteed a 5% return regardless of weather conditions. Thus in warm weather, one dollar invested in B will produce a 20% return, while one dollar invested in A will produce a 10% loss. Investors total return on two dollars invested in A and B will be 5%. Exactly the same result will be obtained for cold weather conditions. This example illustrates that through the magic of diversification regardless of weather conditions one can obtain risk free 5% return on investment.

This must be contrasted with the fact that the two investments A and B are highly risky, because the frequency of a cold or a warm season in a particular year cannot be always ascertained. All that we know is that on average, over a prolonged period of time, half of the time the weather is cold and half of the time it is warm. This however, doesn't mean that every year this will be so. This example shows that as long as activities are affected differently by given factors there is a place for diversification, which will eliminate risk.

The basic idea of MPT is that portfolios of volatile stocks, i.e. risky stocks, can be combined together and this in turn will lead to the reduction of the 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.

However, the theory indicates that the risk of various stocks must 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. Through diversification only unsystematic risk is eliminated, systematic risk cannot be removed through diversification. Consequently it is held that 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 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. In this regard beta 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. Thus if the market goes up 10% the stock tends to rise 20%. If however, the stock has a beta of 0.5% then it tends to be more stable than the market.

Does it make sense?

The MPT framework 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 determine the success or failure of any business. Consequently an investment in stocks should be regarded as an investment in business as such and not in stocks. By becoming an investor in a business an individual has exercised an entrepreneurial activity. In other words he has committed his capital with a view to supply the most urgent needs of consumers.

For an entrepreneur the ultimate criterion for investing his capital is to employ it in those activities that will produce goods and services that are on the highest priority list of consumers. It is this striving to satisfy the most urgent needs of consumers, that produces profits and it is this alone that guides entrepreneurs. The entrepreneurs focus and main consideration while investing his capital is to secure the highest possible profits, not to minimise risk as the MPT suggests. If entrepreneurs strived after what they considered to be the safest investment while neglecting consumers wishes they would render the entire investment unsafe.

The size of an entrepreneur's return on their investment is determined not by how much risk they assume, but whether they comply with consumers' wishes. The fact that entrepreneurs appear to be practicing diversification by investing in various businesses over time doesn't necessarily mean that they do so in order to reduce their investment risk, they may diversify in order to boost their chances of earning profits.

The moment the primary consideration of investment becomes the reduction of risk rather than the attainment of the highest possible profit, then all kind of strange decisions may emerge. For instance, strictly following MPT, one may deliberately invest in an asset that offers a negative return in order to reduce the overall portfolio risk. However, no sane investor deliberately chooses a badly performing investment. It is only the emergence of conditions not properly forecasted by the investor that leads to a bad investment.

According to Mises:

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.

Furthermore, in an attempt to minimize risk, practitioners of MPT tend to institute a high degree of diversification. However, having a large number of stocks in a portfolio might leave little time to analyse 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.

One of the world's most successful stock market investors, Warren Buffett, argues that investor's financial success is in direct proportion to the degree to which he understands investment. This understanding, according to Buffett, is what separates investors with a business consideration from gamblers who merely buy stocks. Buffett says that investors are better served if they concentrate on locating a few spectacular investments rather than jumping from one mediocre idea to another. John Maynard Keynes expressed a similar view:


As time goes on, I become more convinced that the right method of investments is to put fairly large sums into enterprises which one thinks one knows something about and in 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.

Proponents of modern portfolio theory argue that diversification is the key to the creation of the best possible consistent returns. We argue that one must focus on the profitability of the investments in a portfolio, before one considers their contribution to the portfolio's diversification. Consequently, whilst we agree with the general principle of diversification, we believe that the profitability of an individual investment should be the primary consideration for the investor.