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THE JOURNAL OF FINANCE * VOL. XLVI, NO. 2 * JUNE 1991
*Marvin Speiser Distinguished Professor of Finance and Economics, Baruch College, CUNY
and Director of Research, DAIWA Security Trust Company.
?The Nobel Foundation 1990
469
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470 The Journal of Finance
case would the investor actually prefer a diversified portfolio. But diversifica-
tion is a common and reasonable investment practice. Why? To reduce
uncertainty! Clearly, the existence of uncertainty is essential to the analysis
of rational investment behavior.
In discussing uncertainty below, I will speak as if investors faced known
probability distributions. Of course, none of us know probability distributions
of security returns. But, I was convinced by Leonard J. Savage, one of my
great teachers at the University of Chicago, that a rational agent acting
under uncertainty would act according to "probability beliefs" where no
objective probabilities are known; and these probability beliefs or "subjective
probabilities" combine exactly as do objective probabilities. This assumed, it
is not clear and not relevant whether the probabilities, expected values, etc.,
I speak of below are for subjective or objective distributions.
The basic principles of portfolio theory came to me one day while I was
reading John Burr Williams, The Theory of Investment Value. Williams
proposedthat the value Qfa stock should equal the present value of its future
dividend stream. But clearly dividends are uncertain, so I took William's
recommendation to be to value a stock as the expectedvalue of its discounted
future dividend stream. But if the investor is concerned only with the
expected values of securities, the investor must also be only interested in the
expected value of the portfolio. To maximize the expected value of a portfolio,
one need only invest in one security-the security with maximum expected
return (or one such, if several tie for maximum). Thus action based on
expected return only (like action based on certainty of the future) must be
rejected as descriptive of actual or rational investment behavior.
It seemed obvious that investors are concerned with risk and return, and
that these should be measured for the portfolio as a whole. Variance (or,
equivalently, standard deviation), came to mind as a measure of risk of the
portfolio. The fact that the variance of the portfolio, that is the variance of a
weighted sum, involved all covariance terms added to the plausibility of the
approach. Since there were two criteria-expected return and risk-the
natural approach for an economics student was to imagine the investor
selecting a point from the set of Pareto optimal expected return, variance of
return combinations, now known as the efficient frontier. These were the
basic elements of portfolio theory which appeared one day while reading
Williams.
In subsequent months and years I filled in some details; and then others
filled in many more. For example in 1956 I published the "critical line
algorithm" for tracing out the efficient frontier given estimates of expected
returns, variances and covariances, for any number of securities subject to
various kinds of constraints. In my 1959 book I explored the relationship
between my mean-variance analysis and the fundamental theories of action
under risk and uncertainty of Von Neumann and Morgenstern and L. J.
Savage.
Starting in the 1960s, Sharpe, Blume, King, and Rosenberg greatly clari-
fied the problem of estimating covariances. This past September I attended
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Foundations of Portfolio Theory 471
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472 The Journal of Finance
Table I
Correlation Between EU and f(E, V) for Four Historical Distributions
Utility Annual Returns on Annual Returns on Monthly returns on RandomPortfolios
Function 149 Mutual Funds1 97 Stocks2 97 Stocks2 of 5 or 6 Stocks3
Log(1 + R) 0.997 0.880 0.995 0.998
(1 + R)a
a = 0.1 0.998 0.895 0.996 0.998
a = 0.3 0.999 0.932 0.998 0.999
a = 0.5 0.999 0.968 0.999 0.999
a = 0.7 0.999 0.991 0.999 0.999
a = 0.9 0.999 0.999 0.999 0.999
- eb(l+R)
b= 0.1 0.999 0.999 0.999 0.999
b= 0.5 0.999 0.961 0.999 0.999
b= 1.0 0.997 0.850 0.997 0.998
b= 3.0 0.949 0.850 0.976 0.958
b= 5.0 0.855 0.863 0.961 0.919
b= 10. 0.449 0.659 0.899 0.768
'The annual rate of return of the 149 mutual funds are taken from the various annual issues
of A. Wiesenberger and Company. All mutual funds whose rates of return are reported in
Wiesenbergerfor the whole period 1958-67 are included in the analysis.
2This data base of 97 U.S. stocks, available at Hebrew University, had previously been
obtained as follows: a sample of 100 stocks was randomly drawn from the CRSP (Center for
Research in Security Prices, University of Chicago) tape, subject to the constraint that all had
reported rates of return for the whole period 1948-68. Some mechanical problems reduced the
usable sample size from 100 to 97. The inclusion only of stocks which had reported rates of
return during the whole period may have introduced survival bias into the sample. This did not
appear harmful for the purpose at hand.
3We randomly drew 5 stocks to constitute the first portfolio;5 different stocks to constitute the
second portfolio, etc. Since we have 97 stocks in our sample, the eighteenth and nineteenth
portfolios include 6 stocks each. Repetition of this experiment with new random variables
producednegligible variations in the numbers reported, except for the case of U = e - 10(l +R)
A median figure is reported in the table for this case.
EU = E T u(Rt)/ T(1
where T is the number of periods in the sample, and Rt the rate of return in
period t. We also computed various approximations to EU where the approx-
imation depends only on the mean value E and the variance V of the
distribution. Of the various approximations tried in Levy-Markowitzthe one
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Foundations of Portfolio Theory 473
which did best, almost without exception, was essentially that suggested in
Markowitz (1959), namely
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474 The Journal of Finance
Table II
Quadratic Approximation to Two Utility Functions
E = 00.1
R log(l + R) QL(R) AL -l1OOelO(l+R) QE(R) E
'Among the 149 mutual funds, those with E near .10 all had annual returns between a 30%
loss and a 60% gain. Specifically, 64 distributions had 0.08 c E c 0.12, and all had returns
within the range indicated.
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Foundations of Portfolio Theory 475
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476 The Journal of Finance
Second, suppose that the investor has a utility function for which mean-
variance provides a close approximation, but the investor does not know
precisely which one. In this case the investor need not determine his or her
utility function to obtain a near optimum portfolio. The investor need only
pick carefully from the (one-dimensional) curve of efficient EV combinations
in the two dimensional EV space. To pursue a similar approach when four
moments are required, the investor must pick carefully from a three-dimen-
sional surface in a four-dimensional space. This raises serious operational
problems in itself, even if we overcome computational problems due to the
nonconvexity of sets of portfolios with given third moment or better.
But perhaps there is an alternative. Perhaps some other measure of
portfolio risk will serve in a two parameter analysis for some of the utility
functions which are a problem to variance. For example, in Chapter 9 of
Markowitz (1959) I proposed the "semi-variance" S as a measure of risk
where
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Foundations of Portfolio Theory 477
REFERENCES
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