MPT Out in the World

In the real world, MPT CAPM encouraged academics and regulators to push people to highly diversified, low-cost index funds to mimic the market portfolio. This was unquestionably good for investors. Had Harry met Kelly and invented IGT instead, the natural consequence would be to push people toward concentrated hedge fund strategies—strategies that in the real world only rich people were allowed to use. In the real world, with all investors doing the same thing, we saw consolidation of investment management services, with huge funds managed by huge fund management companies. In the IGT world, with every investor different, you would expect to see far more small funds and companies.

Belief in MPT CAPM helped make the markets more efficient cross-sectionally; that is, returns on different asset classes over the same time periods aligned pretty well with their respective risk levels. But, at least arguably, MPT CAPM contributed toward prices diverging from fundamental value. Index fund investors don't ask what something is worth; they want to hold it in proportion to its price. Among other things, it guarantees that they are overinvested in anything overpriced, and underinvested in anything underpriced. It may be impossible to tell overpriced assets from underpriced ones, but that doesn't matter; it's a mathematical certainty the index fund investor has the worst of both worlds. (Of course, as Ken French and John Bogle independently pointed out to me, half the ...

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