If you can diversify over a large
enough M-neutral portfolio of stocks so
that their accumulated unavoidable risk
cancels, then this M-neutral portfolio of
zero volatility must earn the risk-free rate
r. The same must therefore be true of each
M-neutral element of the portfolio. This
leads to the result that:
(u - r) = β(uM - r)
This is the result of the capital asset
pricing model or arbitrage pricing theory:
in a world of rational investors, the excess
return you can expect from buying
a stock is its β times the expected return
of its hedgeable factor. Put differently, you
can only expect to be rewarded for the
unavoidable factor risk of each stock,
since all other risk can be eliminated by
diversification.
Notice that assumption: "if you can diversify over a large enough..." Not only is the rationalist methodology employed to derive this a little shaky, there's still that additional caveat that you have to diversify over a "large enough...portfolio". I'm sure there's some bit I don't know, where at a certain level of diversification you decrease the "risk" to a certain livable amount, so you don't have to be perfectly diversified, but yeah, still seems like a lot of conditionals.
It's a tough thing, trying to make money this way. It's even tougher with the overlay of being conscious of the possibility of pure randomness, and the possibility that skill doesn't exist. The hedge fund rebuttal guy described here doesn't seem to really know that, though, he'll tell you that the top hedge fund guys are just goddamn masters of their game. Modern celebrity kind of hews to the weird logic of hedge funds, too, with certain specific people taking off -- would hedge fund guy claim that Britney Spears was a skillful singer that didn't somehow get swept along in the fickle interest of the public? How would we know? The idea that luck (in the form of randomness) outruns skill every day of the week is something that more people have to be aware of.
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