A corollary of the efficient market hypothesis is that a risk-neutral investor should try to own a share of everything, weighted by market capitalization or the equivalent. The core idea is that the world in aggregate has already decided on a relatively efficient allocation of capital, so an investor without any strong opinion or expert knowledge should trust that allocation.
Modern portfolio theory, however, finds that in a universe of assets that have an expected return and volatility it's almost always (ed: possible) to find an optimal portfolio that exceeds the risk-adjusted return of any individual asset. This allocation depends only on the expected returns and (co)variance of the assets, not on 'stock' quantities like market capitalization, and it would tend to look more like an equal weighting or inverse volatility weighting.
This is pretty trivial to demonstrate. If I own a store, I can hedge against the risk of my store burning down by only managing the store and owning equal-dollar-value stakes of equivalent shops in different cities. I don't want to over-weight ownership of the fancy-pants store in the bougie district because it can still burn down like any other.
What's the reconciliation of these two views? We could hypothesize that large firms should have internal diversification and thus lower volatility and a better Sharpe ratio, but that doesn't seem to hold very often in practice.
How do we reconcile modern portfolio theory and efficient markets?
byu/Majromax inAskEconomics
Posted by Majromax
1 Comment
>Modern portfolio theory, however, finds that in a universe of assets that have an expected return and volatility it’s almost always (ed: *possible*) to find an optimal portfolio that exceeds the risk-adjusted return of any individual asset. This allocation depends only on the expected returns and (co)variance of the assets, not on ‘stock’ quantities like market capitalization, and it would tend to look more like an equal weighting or inverse volatility weighting.
The challenge here is figuring out how to do so such that the out of sample performance is better than just equally weighting everything in the portfolio. That’s actually a very hard problem, and not just because a mean-variance approach is overly simplistic, but because the forecasting of both the variance-covariance matrix and the returns is extremely, extremely challenging.
>If I own a store, I can hedge against the risk of my store burning down by only managing the store and owning equal-dollar-value stakes of equivalent shops in different cities. I don’t want to over-weight ownership of the fancy-pants store in the bougie district because it can still burn down like any other.
I’m not following, this is telling you to (if possible) diversify equal shares across many investments, which is what the EMH is doing. Also, hedging risk as a business owner is a lot different from portfolio management.