Portfolio theory – where are we now?Staunton (2002)), investments made by the business should be expected to generate
a higher return (the discount rate) than this. The average risk premium was 4.5 per
cent p.a. (in real terms) over the same period. The problem is that we have no
reliable mechanism to assess the riskiness of a particular project and relate it to a
risk premium. Managers are probably left to rely on ‘gut feeling’, but at least the
historical risk-free rate and average risk premium provide them with some broad
indication of the required rate of return.
It is completely logical that managers should look at stock market returns
because these are what the free market has priced risky returns. This follows exactly
the same logic as looking at adverts for second-hand cars to try to place a value on
the particular make, model and year of a car in which we are interested. If we bear
in mind that it is through the stock market prices (as well as dividends) that the
fruits of the investment will benefit the shareholders, using a market-determined
rate of return is entirely sensible.l Do not diversify within the business.The evidence tells us that holding investments in
efficient portfolios can eliminate specific risk. Since the typical individual or institu-
tional investor in securities is diversified (not too exposed to specific risk), there
seems no advantage to the shareholders if businesses diversify their own real invest-
ments across industries. Indeed, it has been argued that businesses should take on
real investments that they know best how to manage (in other words, within their
own area of expertise) and leave the diversification to their shareholders.
This theoretical argument is strongly supported by the available evidence.
Walker (2000) looked at takeovers (where one business buys another) in the USA
between 1980 and 1996. He found that takeovers that took businesses into areas
outside of their expertise caused a loss of shareholder value. Conversely, takeovers
that expanded market share or geographical reach in the existing activity led to
a gain in shareholder value. This was supported by Lamont and Polk (2002) who
found, using data from various US businesses that had diversified, that those
businesses that had diversified across different industries tended to have destroyed
shareholder value as a result.
Despite the strength of the evidence, the fact remains that many businesses are
diversified across industries. This contradiction may arise for one or both of two
reasons:
1 Managers are unfamiliar with the principles of portfolio theory, and believe that
the interests of shareholders are best served by inter-industry diversification.
This seems increasingly unlikely to be the case as managers become more famil-
iar with portfolio theory over time.
2 Managers are, not unnaturally, concerned with how risk affects themselves.
Whereas shareholders tend to hold securities in portfolios, this is not very practical
for managers as regards their employments. They usually have only one employ-
ment at a time and are thus exposed to both the specific and the systematic risks
of their businesses. To individual shareholders, the demise of the business will be
unfortunate but not crucial, to the extent that they each hold only perhaps 5 per
cent of their wealth in that business. To managers, the failure of their employer
will probably be something of a disaster, to the extent of loss of employment.
This second point identifies a possible area of conflict between the best interests of
the shareholders and those of the managers, and provides another example of the
agency problem.