A False Assumption
Friday's column pointed out that, contrary to common belief, investors aren't necessarily being theoretically correct if they index the entire stock market. As Dr. Harry Markowitz pointed out, some years back, the postulate that rational investors should own all equities, in proportion to their stock-market worth, relies on the assumption that stock owners will routinely leverage at the risk-free rate. As that is not the case, the theory collapses. There may be valid grounds to own something other than the market portfolio.
(Of course, most investors, behaving as butterfly collectors rather than as engineers, own something other than the market portfolio. But those differences owe to accidental decisions. This column, instead, concerns the intentional reasons that one might digress from orthodoxy.)
This finding comes, indirectly, from Markowitz's paper. Markowitz shows that if leverage is not easily affordable and common, then aggressive investors will deviate from the market portfolio. Per the very logic that recommends the market portfolio--that is, the capital asset pricing model (CAPM)--the higher a stock's beta, the higher its expected returns. Without the use of leverage as a tool, the aggressive buyers will crowd into high-beta stocks.
This behavior could create pricing distortions--that is, make stock prices inefficient. (Markowitz's paper doesn't raise that possibility, but others have.) If too much money chases the same subgroup of high-beta stocks, then those securities may become overbought, and thus deliver weaker-than-expected future returns. Then, as the news of that failure becomes known, investors might flee high-beta stocks, knocking down their prices so that they become bargains.
Perceiving these effects and profiting from them are difficult tasks, to be sure. However, the point remains: Because the stock market does not obey one of CAPM's key assumptions, it may have systematic pricing distortions. That represents an opportunity for active investment managers.
There may be other openings, too. Although (to my knowledge) the interplay between high- and low-beta stocks is the only potential consequence that is suggested by the CAPM, other things could also cause knock-on effects. For example, many observers argue that inflows into index funds have distorted stock prices, boosting shares that are held by the popular indexes and leaving other shares to languish. I disagree, but there's no doubt that such a thing could occur.
Varying Definitions of Risk
The remaining three arguments against owning the stock market portfolio do not involve claims of mispricing. Rather, they reflect differences in personal situations--individual circumstances that can lead two fully rational investors to hold different stock portfolios.
One obvious example is dissimilar needs for liquidity. An investment manager who runs a mutual fund that has few shareholders, with each shareholder commanding a high percentage of fund assets, faces the daily possibility of being forced to sell a big chunk of assets to meet a sudden redemption. Holding stocks that may be traded easily becomes important. In contrast, the investment manager of a closed-end fund faces no such danger.
Because liquidity is only a good thing--it is never bad to have the ability to sell a security quickly and cheaply--stocks that are highly liquid will, all things being equal, be priced somewhat more expensively than those that are difficult to trade. The mutual fund manager who might receive a redemption notice will be willing to accept a somewhat lower future return in exchange for extra liquidity, while the closed-end manager will not. Different preferences, for entirely rational reasons, leading to different portfolios.
The same precept holds true for many other risks. To cite another example, some companies are more economically sensitive than others. Economic sensitivity being an undesirable feature, this attribute leads to these stocks being priced somewhat lower than they otherwise would be, thereby suggesting that they have higher expected returns. Those who can better withstand investment losses during recessions may tilt toward such stocks, while those in the opposite position will not.
People possess two sources of capital: investment and human. Their investment capital exists today. It is the booty that they have accumulated and is represented by financial assets. Their human capital, in contrast, concerns the future. It is the money that workers will make (or, more technically, expect to make, as the value of that human capital is known only when it is realized) through their labor.
Human capital, as with financial assets, carries different levels of volatility. A tenured professor at a wealthy university can reliably estimate the size of her future paychecks, as can a career government official who works in a stable, well-funded department. A real estate developer, not so much. (The last one I encountered defaulted on his obligations, one of which included … me.) All things being equal, the professor and government worker can afford to take more risk with their investment holdings, and the real estate developer less so.
So far, human capital affects the amount of equities that investors might own, but not whether they should deviate from the market portfolio. But it does once industry exposure is considered. Given that automobile stocks tend to trade in unison, the automobile worker who faces the danger of being laid off when the industry slumps would be best off avoiding auto stocks entirely. Indeed, he should be wary of any industry that behaves similarly to the automobile business.
Assets and Liabilities
A final reason not to own the stock-market portfolio is improve the match between personal assets and liabilities. This sounds vague--my first comment upon hearing this suggestion from Morningstar asset-allocation researchers Paul Kaplan and David Blanchett was, "Please give me an example"--but it is actually straightforward. If one can own an asset that tends to rise in price when a liability increases, then attempt to do so.
Thus, the investor with five school-age children who expects to face hefty college payments might wish to invest in inflation-protected securities, as college-tuition hikes are roughly correlated with the rate of inflation. Similarly, older investors who have already covered most of their planned expenditures, and who are starting to plan for purchasing long-term health insurance, might favor healthcare stocks. If medical costs keep rising more rapidly than the general economy, then it may be that both the cost of the insurance premiums and the shares of healthcare firms will also balloon.
This argument is not as strong as that of human capital. It is obvious and useful to avoid holding the shares of stocks that are correlated with one's own company; losing a job while one's portfolio is plummeting is a double whammy. It is not as obvious, nor as clearly useful, to buy inflation-protected securities because perhaps several of one's children will attend college, those bills will need to be paid, and inflation-protected securities will prove to be a sound investment for meeting that obligation. There are too many links in that chain.
Nonetheless, the point remains: While holding the market portfolio is a sensible starting point for investors, and may well end up as the ending point, there are other legitimate investment paths.