Unrewarded Risk

Wall Street often disregards the statistically sound results of years of study by the financial academics. Perhaps this is because much of the profit of Wall Street is based on ideas that are in opposition to the findings of academia. Whatever the reason, you most likely will not hear your broker touting the findings of Nobel laureates. However, the findings of financial academics are no less powerful.

Wall Street, like many individuals who invest in the market, still holds in theory to the findings of Gerald M. Loeb. In The Battle for Investment Survival of 1935 he stated, “Once you attain competency, diversification is undesirable. One or two, or at most three or four, securities should be bought. Competent investors will never be satisfied beating the averages by a few small percentage points.” This concept of “beating” the market and “stock picking” was not challenged until an unknown finance student named Harry Markowitz challenged these ideas in landmark works of 1952. He developed the ideas that diversification can reduce risk and that there is a difference in portfolio risk and security risk. Through these concepts he developed something known as the Markowitz Efficient Frontier.

Today, Wall Street tries to walk Loeb and talk Markowitz. There is much talk about the importance of diversification and minimization of risk. However, performance is still measured by “beating” the market. Therefore, diversification and risk management are little more than terms used in passing conversation. You can’t have it both ways. If you really believe you (or your broker) have a crystal ball and know what stock to pick, why do you need to diversify? The fact is no one has a crystal ball! Thus diversification often becomes damage control for speculation, otherwise known as gambling. This is one of the reasons that most individual equity investor returns trail the market. But despite the unrewarded risks, most individuals and brokers continue to speculate with the hopes that they can be the one to beat the market.

You would presume that half of those playing these odds should beat the market and the other half should loose, however, just like playing in Vegas, the odds are against you. Transaction costs, broker fees, and periods of holding cash outside the market yield the typical equity investor less than half of the markets performance on average. So, before you continue to invest with the emotional hopes of hitting it big, ask yourself what you really believe. Do you really believe one individual is smart enough or knowledgeable enough to outguess every other individual in the world? Because if you believe that supply and demand are effective at controlling prices, then being that knowledgeable is what stock picking means today. Personally, I don’t presume to be quite that intelligent.