Back in the ’70s when I learned about investing, we sophisticated folks understood that financial markets are “efficient” and the Capital Asset Pricing Model (CAPM) would guide us. You could reduce your risk somewhat by having a diversified portfolio, but to get a higher return you’d have to accept more risk of loss. Of course there was no Internet, no easy way to check this for ourselves, but I did get access for a time to a remote terminal connected to a computer which supposedly allowed me to test this theory. I did so, and the results were consistent, tho today I certainly can’t remember the details.
So when I first read Progress & Poverty in the ’80s, I was a bit troubled by this from Book III Chapter 4:
Some people acquire wealth by taking chances which to the majority of people must necessarily bring loss. Such are many forms of speculation, and especially that mode of gambling known as stock dealing. Nerve, judgment, the possession of capital, skill in what in lower forms of gambling are known as the arts of the confidence man and blackleg, give advantage to the individual; but, just as at a gaming table, whatever one gains some one else must lose.
It’s a fine evocation of the way markets are gamed nowadays, but implies that there is on balance no extra return for acceptance of risk. Perhaps in this aspect of investing Henry George was simply incorrect. No shame in that, market data and analysis in 1879 was primitive, and not his main focus anyway. So I put it aside until 1997, when I read John Cochrane’s article (in a Chicago Federal Reserve publication that I can’t seem to find right now). Cochrane suggested that, since we have comprehensive stock market data only for a century or so, perhaps we don’t have enough to properly measure risk; maybe it is really greater than we suppose.
That seemed plausible, if hardly conclusive. But in the past few months I have discovered in two different places (Steve Keen’s lectures under Behavioural Finance here, and Eric Falkenstein’s “Finding Alpha” lectures here) that the CAPM is now considered outmoded. Except among very low-risk or very high-risk assets, risk and return are basically unrelated. So Henry George was right.
{which doesn’t prevent one of the large discount brokerage firms from posting on their web site: “It is a principle of investing that higher potential returns carry higher risk, and conversely, for lower risk, we accept lower expected returns.”]
But if investors who take risk aren’t rewarded with a higher return, why do they accept the risk? Henry George assumes that people “seek to gratify their desires with the least exertion,” yet they could more likely obtain wealth if they avoided more than a nominal amount of risk. Falkenstein cites some evidence (mainly in “Flawed Assumption” chapter here) that people are more motivated by envy than wealth, that being less poor among poor people may be more satisfying than being wealthy among wealthier folk.
To which I suppose Henry George would respond that few people, in the classes able to invest, desire only wealth. But it does raise a problem. Henry George (and modern geoists) assumes that the remedy for poverty is to allow the poor to keep more of the wealth that they produce. But perhaps the main function of the poor is really to allow the rest of us to feel superior? It’s a discouraging thought.