In today’s equity markets, investors face a paradox: share price swings are more dramatic than ever yet often have little to do with a company’s underlying health or earnings. So how can investors achieve true diversification and risk reduction in a world driven by fickle market forces?
Modern Portfolio Theory (MPT), introduced by Harry Markowitz in 1952, revolutionized investing by showing that diversification could optimize the trade-off between risk and return. By combining assets with imperfectly correlated returns, investors can achieve higher expected returns for a given level of risk—or lower risk for a desired level of return.
The Intuitive Appeal of Traditional Risk Concepts
To quantify risk, Markowitz settled on the idea of variance as a proxy. This has intuitive appeal: an asset price that moves erratically suggests uncertainty, which introduces the possibility of permanent loss, or ‘risk.’ Over time, numerous academic papers proved the historical validity of this linkage.
Diversification is similarly appealing. We’ve all been told from an early age never to place all our eggs in one basket. Mountains of empirical evidence support the intuition.
But not so fast. Although MPT makes sense, we believe several behavioral and fundamental factors have eroded the theory’s core tenets and raise questions about its application today.
Technical Forces Fuel Volatility
Trading trends in recent years have rattled risk concepts. The retail trading fervor stoked by COVID lockdowns has been intensified by trading platforms that increase access to derivatives. Since 2016, the total traded value of US over-the-counter equity-linked products has jumped by 64%, according to data from the Bank for International Settlements. Retail traders drove the surge using zero-day options, which reached an average daily record of 2.7 million contracts in October, according to the Options Clearing Corporation.
Zero-day options amplify investor leverage and create rapid feedback loops. Dealers hedge their positions, which affects option prices and necessitates further hedging. This process intensifies at market close, increasing stock-price volatility.
Leveraged exchange-traded funds (ETFs) have also fueled instability. These instruments, which reached a record $239 billion assets under management in September (Display), also create feedback loops; as markets rise, ETF exposure shrinks so the funds must buy, pushing the market higher. Here, too, most activity takes place at the market close when ETFs rebalance, augmenting price volatility.
