Two Nobel Laureates, two answers.
Most people who have studied investing believe that they should possess the market portfolio. With their U.S. stocks, they shouldn’t pick and choose; rather, they should own as many positions as possible, presumably through broad index funds. Ditto for their bonds as well as for their overseas holdings. This belief comes courtesy of Professor William Sharpe, who won a Nobel Prize for his troubles.
Of course, most investors don’t follow this precept precisely. They don’t 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 ITOT (catchy moniker that) or Schwab US Broad Market SCHB, and their portfolios will fluctuate around those benchmarks, but their results shouldn’t stray too far from the mark.
As my colleague Paul Kaplan (to whom this column owes a debt) reminds me, this faith in the market portfolio deserves some rocking. Critically, Sharpe’s conclusion when developing the Capital Asset Pricing Model—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 rate.
In practice, of course, most investors—even among institutions—don’t borrow, and if they do attempt such a thing, they are not granted the risk-free rate. This has a dire effect on the CAPM. Writes fellow Nobel Laureate Harry Markowitz (who received his award on the same day as Professor Sharpe), 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 was correct on the math. His results have not been challenged.
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 actual world, not so much.
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.