On the diversity of equity markets (Q1300422)

In this paper, market capitalization of a firm is assumed to follow a diffusion process with drift. The market portfolio is the average capitalization. The author points out that, asymptotically, the average of a fixed number of diffusion processes is dominated by one of its components. This is interpreted as the disappearance of market diversification. The author defines dividends as a process which rebalances the composition of the market portfolio and argues they are needed to maintain portfolio diversification. It has long been argued that dividends are almost irrelevant. At the level of the individual investor, if a corporation does not pay dividends, a stockholder can always sell some shares. Conversely, if a corporation pays unwanted dividends, the shareholder can choose to reinvest them by buying new shares. At the level of the firm, i.e. at the level of the aggregate shareholder, a corporation that pays dividends can restore its market capitalization by issuing new shares, and many do so. Hence, the characterization of dividends by the author is really stretching the usual definition. In fact, what the author argues is that, unless corporations choose to reduce their market capitalization, one firm will end up dominating the stock market and, by implication, the economy. The question of why firms should do so is not addressed in this paper. Indeed, it would seem it would be in the interest of the managers of a firm to let the company grow as much as possible. So, why are we not witnessing a forever concentration of capital in the hands of one company? The answer is that the rate of return on capital invested in a company is not independent of the size of the company (as the author assumed), and the same holds for portfolios of securities. A good example is the case of Fidelity's Magellan fund, which performed brilliantly as long as it was retained a manageable size, but floundered when the inflow of fresh capital overwhelmed the ability of the fund manager to find profitable use for the capital at hand.