Financial diversification before modern portfolio theory: UK financial advice documents in the late nineteenth and the beginning of the twentieth century

Abstract

The paper offers textual evidence from a series of financial advice documents in the late nineteenth century and the early twentieth century of how UK investors perceived of and managed risk. In the world's largest financial centre of the time, UK investors were familiar with the concept of correlation and financial advisers’ suggestions were consistent with the recommendations of modern portfolio theory in relation to portfolio selection strategies. From the 1870s, there was an increased awareness of the benefits of financial diversification – primarily putting equal amounts into a number of different securities – with much of the emphasis being on geographical rather than sectoral diversification and some discussion of avoiding highly correlated investments. Investors in the past were not so naïve as mainstream financial discussions suggest today.

Keywords:

• Diversification
• Markowitz
• portfolio theory
• portfolio risk
• capital flows

JEL Classifications:

• B10
• B30
• G11

Acknowledgements

We would like to thank Maria Cristina Marcuzzo and the participants in the session “Debt, finance and risk” of the 19th annual conference of the European Society of the History of Economic Thought (Roma Tre University, Rome, 14–16 May 2015) for their suggestions and critical comments. We would also like to thank the two anonymous referees for their valuable points and critical comments on the first version of this paper. The responsibility for any remaining errors or omissions is of course ours alone.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1 The famous Capital Asset Pricing Model (CAPM), mostly associated with the names of Sharpe (1964) and Lintner (1965), was the “logical” next step. It approached the risk of an individual asset through the lens of diversification theory. In the 1960s, given limitations in computing power, financial practitioners were more interested in a simple methodology by means of which they could value the risk of an individual security. Drawing upon Markowitz's formalisation, CAPM (itself based on some very limited assumptions) offered investors this simple tool. According to the latter, the risk of every financial security comprises two components: the systematic risk and the unsystematic risk. The unsystematic part is idiosyncratic and can be reduced through diversification. The systematic risk is related to the market variation as a whole and cannot be diversified away. Thus, it is only the systematic risk which is relevant in determining the return. There is no premium for bearing risks that can be eliminated through diversification. In the following sections of this study, we see that a similar division of security risk into specific and systematic can be found in the financial discussions, both in the UK and France before the First World War.

2 Cheffins (2010, p. 127). See also Foreman-Peck and Hannah (2011, p. 1222) and Rutterford (2009).

3 For this performativity approach see Deleuze (2012) and Derrida (1988).

4 A trust is an arrangement whereby a person (trustee) holds property as its nominal owner for the good of one or more beneficiaries. In this instance, trusts were often set up for widows and children, on the death of the husband. Prior to 1893, trustees who were restricted to investing only in so-called “trustee investments” could only purchase Consols. The Trustee Act of 1893 allowed trustees to purchase safe British and colonial government stocks, in particular those of India, UK and Indian Railway debentures and some “safe” railway preference shares, as well as Bank of England and Bank of Ireland stock.

5 Chadwicks’ Investment Circular (1870, p. 52).

6 Chadwicks’ Investment Circular (1871, p. 38).

7 This categorisation is not explicit in the texts of the period, but it is implied by them. For further discussion, see Rutterford (2004) on how yields were used as a valuation tool to take account of risk.

8 Another way for investors to improve information flow was to live close to the company's headquarters, area of operations and/or location of annual general meetings. For more discussion on local investment bias at the time, see Rutterford et al. (2015).

9 See Thomas (1973, p. 66, 123).

10 Liverpool Daily Post, 5 September 1870.

11 See Hughes (2005) and Elliot (2006).

12 For an overview of the UK investment trusts see Rutterford (2009).

13 Guldhall Library, MS 18000, File 1223.

14 McKendrick and Newlands (1999, p. 26).

15 The Times, 20 March 1868, p. 10.

16 Scratchley (1875, p. 16), see also Rutterford (2009, p. 161).

17 Prospectus, Guildhall Library, MS 14235.

18 We are referring here to Lowenfeld (1907). This intervention was initially discussed by Goetzmann and Ukhov (2006) and later by Mitchell et al. (2011) and Edlinger and Parent (2014).

19 The very same principles were also thorough developed in Lowenfeld (1907).

20 The emphasis on nominal rather than market value reflected the relative disregard for capital gain or loss compared with yield as a source of return. Some publications were unsophisticated as to the number of securities to choose and the difference between nominal and market values as far as diversification was concerned. For example, the weekly Investors’ Review, in 1905, recommended a model trust with four securities of nominal value £100 each, with market prices varying from £102 ½ for Buenos Ayres Railway Debentures paying 5% nominal to £280 for Nobel Dynamite shares paying 10% nominal yield (Investors’ Review, November 11, 1905: 594).

21 The Times, Friday 9 January 1914, p. 13.

22 The Times, Thursday 15 January 1914, p. 13.

23 A discussion on the creation of the discipline of financial economics see Jovanovic (2008).

24 This definition of knowledge goes beyond the distinction between academic and vernacular science. For related discussions and debates see Preda (2004), Jovanovic (2006b) and Preda (2006).

25 See Goetzman and Ukhov (2006) and Chabot and Kurz (2010). On the contrary, Edlinger et al. (2013) argue that, while diversifying, British investors at the LSE showed a foreign bias.