The measure of a market (a really old one)

A year ago, about this time, I was on my way to Ottawa for the Canadian Economic Association and Canadian Network of Economic History Meetings. They coincided, so I presented papers at both and took the opportunity to adamantly assert that I was not an economic historian.

A year later, I have a book chapter, a working paper, a paper (almost–I’m just waiting for confirmation it was sent out) under review, and a paper idea percolating that all belong under the label Economic History. I’m trying to get the paper idea in shape to submit to the CNEH meetings again this year, with the deadline fast approaching.

While my coauthors and I were hard at work on the paper on financial portfolios in the early 18th century, the one that is (almost) under review, a seminar participant at Stanford asked my coauthor what an optimal portfolio would look like. We didn’t know. None of us is really a finance person. I got involved with the project because it had a gender component and the others on the papers are economic historians.

I took it upon myself to pick the brain of my colleague who teaches finance at Gettysburg and found myself quickly immersed in the heady world of portfolio optimization, betas, alphas, indices, Markov matrices, and so much more. From my understanding of the literature, the S&P500 represents the closest thing we have to an optimal portfolio, and so creating a similar index for the time period we’re interested in should provide the answer to the seminar participant’s question.

What I find particularly interesting about the index method of portfolio construction is that the S&P500 in particular is thought to provide an accurate picture (returns and growth-wise) of a balanced portfolio of all assets–not just financial instruments. If you were to put a big chunk of your money in a fund that purchased stocks along with the S&P market capitalization strategy, you would actually be bringing your portfolio out of balance by buying things like real estate or durable investment goods.

The idea, I believe, is that the stock market has “evolved” such that it captures the risk and reward of all those types of instruments–not just the stocks themselves. I find this assumption, particularly given the dramatic dips and peaks in the stock market we’ve seen over the past four or five years to be heroic, at best, but it becomes more problematic when we turn to 1700s finance.

The financial instruments available in the period for which I have data are incredibly few in number and even more limited in scope. Besides a bank or two, they are joint-stock, charted trading companies, whose fortunes lie entirely in the wind and the water and the ability of colonists to extract resources from the colonies. There’s no ability to invest in steel or textiles or the machines that make them. I don’t have information about real estate or other investments for most of the people in the sample, and I certainly don’t have their prices. So, our optimal portfolio can really only be for the available stocks, not for the entire gamut of instruments.

I doubt that I’ll be the one to rewrite modern portfolio theory, and I do think this is the best place to start, but it’s not ideal. Story of an economics paper, I guess.


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