You have learned that a basic principle in portfolio management is the diversification of securities. Even if all stocks are priced fairly, each still poses firm-specific risk that can be eliminated through diversification. Therefore, rational security selection, even in an efficient market, calls for the selection of a well-diversified portfolio, providing the systematic risk level that the investor wants. Even in an efficient market investors must choose the risk-return profiles they deem appropriate.
The efficient market hypothesis (EMH) states that a market is efficient if security prices immediately and fully reflect all available relevant information. If the market fully reflects information, the knowledge of that information would not allow an investor to profit from the information because stock prices already incorporate the information. In an efficient market, no securities are consistently over-priced or under-priced. While some securities will turn out after any investment period to have provided positive alphas (i.e., risk-adjusted abnormal returns) and some negative alphas, these past returns are not predictive of future returns.
Proponents of the efficient market hypothesis believe that active management is largely wasted effort and unlikely to justify the expenses incurred. Therefore, they advocate a passive investment strategy that makes no attempt to outsmart the market. A passive strategy aims only at establishing a well-diversified portfolio of securities without attempting to find under or overvalued stocks. Passive management is usually characterized by a buy-and-hold strategy. Because the efficient market theory indicates that stock prices are at fair levels, given all available information, it makes no sense to buy and sell securities frequently, which generates large brokerage fees without increasing expected performance.
Rational investment policy also requires that tax considerations be reflected in security choices. High-tax-bracket investors generally will not want the same securities that low-tax-bracket investors find favorable. At an obvious level, high-bracket investors find it advantageous to buy tax-exempt municipal bonds despite their relatively low pre-tax yields, whereas those same bonds are unattractive to low-bracket or tax-exempt investors. At more subtle level, high-bracket investors might want to tilt their portfolios in the direction of capital gains as opposed to interest income, because capital gains are taxed less heavily and because the option to defer the realization of capital gains income is more valuable the higher the current tax bracket. They also will be more attracted to investment opportunities for which returns are sensitive to tax benefits, such as real estate ventures.
A third argument for rational portfolio management relates to the particular risk profile of the investors. For example, a Toyota executive whose annual bonus depends on Toyota’s profits generally should not invest additional amounts in auto stocks. To the extent that his or her compensation already depends on Toyota’s well-being, the executive is already over-invested in Toyota and should not exacerbate the lack of diversification.
In conclusion, there is a role for portfolio management even in an efficient market. Investors optimal positions will vary according to factors such as age, tax bracket, risk-aversion, and employment. The role of portfolio management in an efficient market is to tailor the portfolio to these needs, rather than to attempt to beat the market, which requires identifying the client’s return requirements and risk tolerance. Rational portfolio management also requires examining the investor’s constraints, including liquidity, time horizon, laws and regulations, taxes, and unique preferences and circumstances such as age and employment.