Many people who have studied investing believe that owning the whole stock market, through a passive fund, is the best way to invest. They shouldn’t pick and choose; rather, they should own as many positions as possible, through broad index funds for both stocks and bond holdings. This belief comes courtesy of Professor William Sharpe, who won a Nobel Prize for his troubles.
Of course, most investors do not follow this principle exactly. They do not hold a single broad-market index for each asset class. Nonetheless, if they invest through funds rather than through stocks directly, investors will end up owning something that approximates Sharpe’s recommendation.
They will pay more than the annual 3 basis points levied by iShares Core S&P Total US Stock Market ETF (listed in the U.S.) or Schwab US Broad Market ETF (listed in the U.S.), and their portfolios will fluctuate around those benchmarks, but their results should not stray too far from the mark.
As my colleague Paul Kaplan reminds me, this faith in the market portfolio deserves some rocking. Critically, Sharpe’s conclusion when developing the Capital Asset Pricing Model (CAPM) – that the market portfolio was the single best portfolio for all investors – depends upon the assumption that investors can and will borrow to leverage their portfolios. In addition, the interest rate for their borrowing costs must be the risk-free bank rate.
Where the Theory Does Not Work
In practice, of course, most investors, even among institutions, do not borrow money to invest with, and if they do attempt such a thing, they are not granted the risk-free rate. This has a dire effect on the CAPM. According to fellow Nobel Laureate Harry Markowitz, if we “take into account the fact that investors have limited borrowing capacity, then it no longer follows that the market portfolio is efficient.”
In fact, continues Markowitz, “This inefficiency of the market portfolio could be substantial and it would not be arbitraged away even if some investors could borrow without limit.” He then defends that statement formally, for those who enjoy such treatments. Suffice it to say that while the equations are past the scope of this column, the upshot is not: Markowitz’s maths was correct. His results have not been challenged.
Behaviour Creates Pricing Distortions
Markowitz draws a straightforward investment conclusion. In the theoretical world of the CAPM, investors achieve extra return by borrowing to buy additional equities. That is, they increase their portfolios’ betas by putting more money to work at a beta of 1.0 – the market portfolio, rather than investing the same amount of money in stocks that have higher betas. In the real world, this is not the case.
That is because without borrowing, only the latter strategy is possible. Those who accept the CAPM’s conclusion that beta alone determines a stock’s expected future returns, and who are willing to accept above-market risk in exchange for potentially above-market gains, must purchase higher-beta equities. No ifs, ands, or buts. That is their only choice. Such investors must reject the market portfolio by doubling down on volatile stocks and skipping the tame ones.
The problem is, such behaviour introduces pricing distortions. If enough investors adopt this mindset – a likely occurrence, given how many assets are held either by institutions that have very long time horizons, or individuals who have decades of expected life remaining – then higher-risk stocks will become overbought. Too much money will crowd into the same subset of securities, which will reduce their expected returns. Conversely, the low-beta stocks will be relatively neglected, and will outdo their forecasts.
Those results have indeed occurred since the CAPM was introduced, leading some to speculate that Markowitz got it right, even if he didn’t form his argument as a prediction. Readers appreciated the CAPM’s logic, which earned Sharpe fame, but the publication of the theory didn’t much change their habits. For the most part, those who sought greater returns continued not to leverage their portfolios, and continued to seek extra profits by purchasing riskier stocks. The stock market acted largely as it always did.
Creating Counter Ripples
The effect of restricting leverage does not stop there. For every pricing distortion, the financial markets have a potential counter-distortion; a reaction against the original movement. That is, if higher-beta stocks did indeed become overpriced due to excess demand and lower-beta stocks underpriced, and investors perceive that pattern, then stock buyers may change their collective behaviour. Perhaps they will flock to low-beta stocks.
Which then might cause further reverberations. None of which matter for the purposes of this discussion. The point is, once the door is opened such that some participants should refuse to hold the market portfolio, then all manner of beasties can slip into the room. The theory does not permit the halfway, either it holds, or it does not hold. And it doesn’t hold.
Personal Factors Impact Investing
None of which, of course, demonstrates that buying the market portfolio is a mistake, or that thinking of such a position as a “neutral” starting point is wrong. The market portfolio may well be an appropriate choice, and it surely is the most sensible of starting points. The prospective investor in any stock market has several thousand stocks available to them. Without further information, the most-logical portfolio is that which owns them all, in proportion to their worth.
However, there is further information. In addition to Markowitz’s observation, which affects all market participants, there are a host of personal factors that could lead the logical investor to deviate from the market portfolio. These should always be considered before investing.
