I mentioned this to an officemate years ago once, but I never was quite satisfied with the explanation that there is a certain amount of excess return built into the price of a company’s stock as its risk premium, but which can be diversified away through some portfolio of disparate stocks.

If, merely by holding a diversified portfolio, the aggregate risk can be reduced, then one would expect the return demanded for such a portfolio to be less than the sum of the returns of the individual stocks. Yet this is not the case. So we must assume either the portfolio is overperforming, the individual stocks are underperforming, or both. On the other hand, it would seem that the risk premium of any individual stock would be arbitraged away by people holding the most diversified portfolios containing it, thus it is strange that an individual stock could retain an undiversified risk premium. Thus it must not, at least not fully. Its return (and the price it sells for) is also determined by the availability for sale of other not-fully-correlated stocks and their characteristics, even ones that have no material effect on the company’s performance. This is a sure sign of value arising from the demand for the instrument unrelated to its underlying. It would seem to be mispriced as an individual stock. Perhaps an equilibrium will be struck, but it is still paradoxical to talk about the risk premium of individual stocks as a property of that stock alone.

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This guy proposes the use of a 2x leveraged market ETF to “beat” the market in the long term, assuming the market goes up in the long term (that is, the value of the mean path at a much later time is higher, or, perhaps just the marginal expected value is higher at a much later time).

It seems like a nice idea, but something is off. Firstly, these are leveraged portfolios with forced daily rebalancing, so depending on the amount of daily price variability, there is a non-trivial loss of several percent a year on top of costs. If a long-term leveraged position is wanted, one may as well buy the appropriate derivatives that underlie these ETFs, if that can be done.

Secondly, leverage is not free. This WSJ article nails the fixation on returns …

Until recently, public companies, mutual funds and pension funds generally steered clear of such risks. But the lines between risk takers and mainstream investors are blurring. In part, that’s because stock-market returns aren’t what they were a few years back. Between 2000 and 2006, the average annual return on the S&P 500 stock index was 2.5%, down from 28.7% between 1995 and 1999. Using derivatives and borrowed money is one way to try to boost returns.

… but although the return is better, the risk-adjusted return is more useful to look at. With true 2x leverage, only the risk premium is doubled at best, not the total return. On the other hand, if true 2x total return is supplied as they say, the implied leverage, and hence risk, has to be much higher than 2x. That’s something to look out for. Granted, the amount of leverage can be adjusted by weighting with the 1x portfolio.

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I actually find market efficiency arguments quite appealing, but when the assumptions are not made clear, the inevitable hand-waving gets to be irritating…

Here’s some random guy’s page. He’s a big proponent of using a total market portfolio: http://homepage.mac.com/j.norstad/finance/total.html

His hand-waving is almost convincing, almost. Okay, “J. Norstad”, let’s take you point by point.
(Read the article)

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