Risk-Return Analysis, Volume 2: The Theory and Practice of Rational Investing
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The Nobel Prize-winning Father of Modern Portfolio Theory returns with new insights on his classic work to help you build a lasting portfolio today
Contemporary investing as we know it would not exist without these two words: “Portfolio selection.” Though it may not seem revolutionary today, the concept of examining and purchasing many diverse stocks—creating a portfolio—changed the face of finance when Harry M. Markowitz devised the idea in 1952.
In the past six decades, Markowitz has risen to international acclaim as the father of Modern Portfolio Theory (MPT), with his evaluation of the impact of asset risk, diversification, and correlation in the risk-return tradeoff. In defending the idea that portfolio risk was essential to strategic asset growth, he showed the world how to invest for the long-run in the face of any economy.
In Risk Return Analysis, this groundbreaking four-book series, the legendary economist and Nobel Laureate returns to revisit his masterpiece theory, discuss its developments, and prove its vitality in the ever-changing global economy. Volume 2 picks up where the first volume left off, with Markowitz’s personal reflections and current strategies. In this volume, Markowitz focuses on the relationship between single-period choices—now—and longer run goals. He discusses dynamic systems and models, the asset allocation “glide-path,” inter-generational investment needs, and financial decision support systems.
Written with both the academic and the practitioner in mind, this richly illustrated volume provides investors, economists, and financial advisors with a refined look at MPT, highlighting the rational decision-making and probability beliefs that are essential to creating and maintaining a successful portfolio today.
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Risk-Return Analysis, Volume 2 - Harry M. Markowitz
RISK-RETURN
ANALYSIS
The Theory and Practice
of Rational Investing
Volume II
HARRY M. MARKOWITZ
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Copyright © 2016 by Harry M. Markowitz. All rights reserved. Printed in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without prior written permission of the publisher.
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e-ISBN: 978-0-07-183010-2
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Library of Congress Cataloging-in-Publication Data
Markowitz, H. (Harry), 1927-
Risk-return analysis : the theory and practice of rational investing vol. 2 / by Harry Markowitz.
pages cm
Includes bibliographical references.
ISBN-13: 978-0-07-183009-6 (alk. paper)
ISBN-10: 0-07-183009-X (alk. paper)
1. Investment analysis. 2. Investments—Mathematical models. 3. Portfolio management. II. Title.
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2013018660
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Ode to Rationality
There once was a Rational Man,
Who loved his Rational Wife,
They had four Rational Children,
And lived a Rational Life.
They had a Rational Dog,
That chased their Rational Cat,
Who tried as it would,
Never quite could,
Catch the Irrational Rat.
—Harry M. Markowitz
"The Moving Finger writes; and, having writ,
Moves on: nor all your Piety nor Wit
Shall lure it back to cancel half a Line,
Nor all your Tears wash out a Word of it."
—From The Rubaiyat of Omar Khayyam
Translated by Edward Fitzgerald
ADDENDUM TO VOLUME I
On Page 45 of Volume I, copy reads as follows:
. . . , if two utility functions U and V are related linearly,
the probability distribution that maximizes EU also maximizes expected variance (EV).
Copy should read as follows:
. . . , if two utility functions U and V are related linearly,
The probability distribution that maximizes EU also maximizes EV.
The expected variance
error was mistakenly inserted during the editing process. I regret that I did not catch it in the proofs.
CONTENTS
Addendum to Volume I
Preface
Acknowledgments
6. The Portfolio Selection Context
Introduction
Temporal Structure and Today’s Choice
Stakeholders Versus the Investor
Investor Roles
Diversification Needs and Opportunities: Recognized and Unrecognized
Agenda: Analysis, Judgment, and Decision Support Systems
7. Modeling Dynamic Systems
Introduction
Definitions
The EAS-E Worldview
The Modeling Process
An EAS Example
Graphical Depiction of Attributes
Graphical Depiction of Sets
Further Specifications
Describing Time
Simultaneity
Endogenous Events Versus Endogenous Phenomena
JLMSim Events
Simplicity, Complexity, Reality
The SIMSCRIPT Advantage
GuidedChoice and the Game of Life
The GC DSS Database
Simulator Versus DSS Modeling
Issues and Alternatives
The SIMSCRIPTs
The Process View
Subsidiary Entities
SIMSCRIPT III Features
Continued in Chapter 12
8. Game Theory and Dynamic Programming
Introduction
PRWSim (a Possible Real-World Simulator)
Concepts from Game Theory
Non-Theory of Games
Games
Randomized Strategies
The Utility of a Many-Period Game
Dynamic Programming
Solving Tic-Tac-Toe
Conditional Expected Value: An Example
Generalization
Partitions, Information, and DP Choice: An Example
Generalization: Two Types of Games
The Curse of Dimensionality
Factorization, Simplification, Exploration, and Approximation
9. The Mossin-Samuelson Model
Introduction
The MS Model and Its Solution
Markowitz Versus Samuelson: Background
Glide-Path Strategies and Their Rationales
Relative Risk Aversion
The GuidedSavings Utility Function
The Well-Funded Case
A Game-of-Life Utility Function
10. Portfolio Selection as a Social Choice
Introduction
Arrow’s Paradox
The Goodman and Markowitz (1952) (GM) Theorems
Social Ordering for RDMs
Hildreth’s Proposal
Markowitz and Blay (MB) Axioms
Arithmetic Versus Geometric Mean Utility
Symmetry Revisited
Rescaling Ploys
Voting Blocks
The Luce, Raiffa, and Nash (LRN) Choice Rule
Nash Symmetry
A Proposal
Liberté, Égalité, Prospérité
11. Judgment and Approximation
Introduction
EU Maximization: Exact, Approximate; Explicit, Implicit
The Household as Investor
The Markowitz and van Dijk Methodology
The Blay-Markowitz NPV Analysis
The TCPA Process
Estimating PV Means, Variances, and Covariances
Displaying the Efficient Frontier
Resampled AC/LOC Portfolios
TCPA 1.0 Assumptions
Beyond Markowitz
Buckets
: A Brief Literature Review
The Answer Game
First the Question, Then the Answer
12. The Future
Introduction
JSSPG
Proposals
Current Practice
Agenda
Level 6
SIMSCRIPT Facilities
IBM EAS-E Features
Like the Phoenix
Level 7
SIMSCRIPT M Enhancements
Computing: Past, Present, and Future
Von Neumann (1958): The Computer and the Brain
The Computer and the Brain, Revisited
Emulation, Not Replication
Event Invocation of a Third Kind
Processes That Process Processes
Easily Parallelized Processes (EPPs)
Local Resource Groups
Micro Versus Macro Parallelization
Epilogue
Notes
References
Index
PREFACE
This is the second volume of a four-volume book on Risk-Return Analysis: The Theory and Practice of Rational Investing. The theory upon which this book is based is the theory of rational choice
of von Neumann and Morgenstern (1944) and L. J. Savage (1954). While this theory applies to rational choice in general, rather than to rational investing specifically, for the most part the practice discussed in this book involves investing. In particular, a central theme throughout the volumes of this book is that risk-return analysis—and especially mean-variance analysis—is a practical way for an investor to approximate the actions of a von Neumann and Morgenstern or L. J. Savage rational decision maker (RDM).
Volume I was concerned with single-period choice in risky situations with known odds. The present volume is concerned with many-period analyses, still assuming known odds. Volume III will be concerned with single- or many-period analyses, but with unknown odds, i.e., the case of choice under uncertainty. Volume IV will deal with items of importance to financial theory and practice that do not fit neatly into the exposition of the first three volumes.
Volume I repeatedly deplored what I refer to as the Great Confusion
in our field, namely the confusion between necessary and sufficient conditions for the beneficial use of mean-variance analysis. Normal (Gaussian) return distributions are a sufficient but not a necessary condition. If one believes (as I do) that rational choice among different probability distributions requires maximizing expected utility, then the necessary and sufficient condition for the practical applicability of mean-variance analysis is that a carefully selected mean-variance combination from the MV efficient frontier will approximately maximize expected utility for a wide variety of concave (risk-averse) utility functions. A central purpose of Volume I was to dispel the Great Confusion—by showing that, indeed, typically the right choice
(for the particular investor) from an MV frontier will approximately maximize expected utility even when the return on the associated portfolio is not normally distributed.
A central purpose of the present volume concerns the relationship between single-period choice—now—and longer-run goals. In particular, the volume deals with issues like investment for the long run, the asset allocation glide-path
that the investor should use when approaching retirement, the balancing of intergenerational investment needs and, generally, the decision rules that should be incorporated into financial decision support systems. In particular, the last chapter of this volume asks what such financial decision support systems will be like a few decades from now.
WARNING: SOME MATH REQUIRED
It has come to my attention that some buyers of Volume I expected nonmathematical works. (The rare use of a first derivative can be ignored by the reader with no calculus.) As in Markowitz (1959), the present volume contains a sequence of concepts that are well known to many, but will be a struggle for others. For example, as crucial as the concept covariance
was to Markowitz (1959), and von Neumann and Morgenstern’s expected utility
was to Volume I of this book, so is the concept of conditional expected value
to the present volume. It is not sufficient to sort of get the general idea
of what conditional expected value is in order to understand many-period rational choice. One must understand the concept’s formal definition, and how this relates to the general idea
; otherwise it is impossible to follow any formal analysis. In that case, you must rely on my (or someone else’s) authority rather than seeing for yourself what logic implies about the concept.
Chapter 3 of Markowitz (1959), where the math stuff starts, begins with a section titled Mathematics and You
that offers advice like don’t try to speed-read this volume
and do try to understand proofs.
I have one more word of advice: Do not be discouraged if you don’t understand a concept the first time you read it. Think about it; perhaps read on a bit to see how the concept is used, and then return to the definition of the concept.
A few hard
proofs are segregated into one or more paragraphs headed PROOF and ending QED. These may be skipped or skimmed by nonmathematicians.
Otherwise, proofs
are part of the text, as explanations as to what implies what, and why.
As to those who are already quite familiar with such things as conditional expected value, strategy
as defined by von Neumann and Morgenstern, and the dynamic programming principle, I hope that Markowitz (1959) is a sufficient demonstration that it is possible for a book to take the time to bring a dedicated newcomer up to speed on requisite basic principles, and then go on to present novel ideas that are worth the attention of thought leaders in several fields of both theory and practice.
TIME MARCHES ON
The following true—but misleading—story appears in print now and then, including once in the Wall Street Journal by a well-known financial columnist. When I worked at the RAND Corporation, circa 1952, I was offered the choice of a stock/bond portfolio in the form of CREF versus TIAA. I chose a 50-50 mix. My reasoning was that if the stock market rose a great deal, I would regret it if I was completely out of the market. Conversely, if stocks fell a great deal and I had nothing in bonds, I would also have regrets. My 50-50 split minimized maximum regret. The conclusion that some commentators draw from this story is that even Markowitz, creator of MPT, does not use MPT in his own choice of portfolio.
The 50-50 split was my choice at age 25 in 1952. But it would not be my recommendation for a 25-year-old now. My recommendation now would be much more heavily weighted toward equities, perhaps as much as 100 percent equities, depending on the individual’s willingness to put up with fluctuations in portfolio value in the short run. Between 1952 and now a vast MPT infrastructure has been built. In 1952 there was the Markowitz (1952a) article, but no optimizers had been programmed, and no return-series data (such as that of Ibbotson 2014, or Dimson, Marsh, and Staunton 2002) were readily available. Nor had there been decades of discussion on how to use the MPT apparatus, as I have since enjoyed with the friends and colleagues I thanked in the acknowledgments in Volume I.
As to how I invest now, I have participated in the generation and use of efficient frontiers by many of my clients (such as 1st Global of Dallas, Texas, sponsor of this book, and GuidedChoice, described in Chapter 7) using forward-looking estimates of the means, variances, and covariances for the now commonly used asset classes. I know from repeated exposure the approximate asset class mix that I prefer, and I invest in that mix, roughly. I implement my choice with ETFs for equities, and with individual bonds for fixed income.
My theoretical views have also evolved over time. For example, the focal subject of Volume I of the present book—namely, the efficacy of mean-variance approximations to expected utility—was not in my 1952 paper: It made its first appearance in my 1959 book. The relationships presented in 1952—between the mean and variance of a portfolio and the means, variances, and covariances of securities—did not change. These are mathematical relationships. But how the relationships are to be applied, and the justification for their use, has evolved over time, with the largest change in my views occurring between 1952 and 1959. (Markowitz 2010a contains a detailed comparison of the views I held in 1959 versus those I held in 1952.)
A more immediate example of the evolution of my views is the fact that the present volume is not exactly as forecasted in Volume I. The basic topic is still rational investment for the many-period game with known odds, but the precise contents evolved in some unanticipated directions as I reexamined the subject in greater detail. In particular, as my exposition in Chapter 6 (the first chapter of this volume) unfolded, it became clear that the traditional portrayal of The Investor
as a lone wolf, and the portfolio selection process as having only one stakeholder, was wide of the mark. This led to the exploration and inclusion of paths that I had not anticipated originally.
Nevertheless, Volume II as forecast is still here, including the dynamic programming principle, the Mossin-Samuelson model, the Markowitz–van Dijk quadratic approximation to the dynamic programming derived utility function,
and the Blay-Markowitz tax-cognizant portfolio analysis.
FRIENDLY DISPUTANTS
The theory we present in this volume consists of what Hume refers to as logical or mathematical relationships between ideas. Unless I have a bug in a proof somewhere, these relationships are beyond dispute. What is disputable—and disputed!—is how the principles encapsulated in these relationships are to be applied to practical issues. I have not been shy about forcefully arguing my own views on such issues. Inevitably I have disagreed with colleagues for whom I have the highest respect. Paul Samuelson is the most outstanding example. Other examples include Chhabra, Evensky, Ibbotson, Merton, Shefrin, Statman, and others. My friends know that I get great joy and much value from the give-and-take dialectic process that characterizes a living, growing field of knowledge. I take no offense when a colleague proposes to take investors Beyond Markowitz,
and expect none to be taken when I, in turn, offer to take investors Beyond ‘Beyond Markowitz.’
As I said, all this is known to my friends. I just want to assure third-party readers that—almost tautologically—I have the highest respect for those whose views I consider worth reproducing here, whether or not I agree with those views.
AUTHORSHIP
The section in Chapter 11 on the Blay-Markowitz TCPA (tax-cognizant portfolio analysis) is the joint work of Ken Blay and me. Other than that, all words penned, as well as the views expressed, are mine. In the preface to Volume I, after thanking 1st Global in general and Tony Batman in particular for sponsoring this book, I noted that Kenneth Blay has been my chief contact with 1st Global on this and other matters. . . . Given our close and continuing relationship in the production of this book, it seemed to me that the appropriate acknowledgment for Ken Blay was to list him as a joint author. This relationship continued until recently, but now Ken is no longer a 1st Global employee. (This too has changed.) I have not taken the trouble to change
we to
I for most of this volume, except for Chapter 12 which is listed as an essay by me. This is because Chapter 12 contains recommendations for the building of real-time decision support systems that are contrary to the currently accepted doctrine by the leaders in this field. A crucial piece of my argument is based on personal experience with an alternative approach: I have been there; done that; it really works a lot better than the way things are done currently. By writing in the first person singular, I could say
I instead of
Markowitz says."
ACKNOWLEDGMENTS
The writing of this volume gave me the opportunity to reexamine my positions on many aspects of the portfolio selection context, temporal and otherwise, and to write out my current views on these matters, including both longstanding views and those developed concurrently with writing. As in Volume I, I wish to express my indebtedness to Stephen A. (Tony) Batman for making this all possible. I also want to thank Mary Margaret (Midge) McDonald for patiently deciphering and typing countless drafts in which I moved great batches of heavily edited material from here to there; Lilli Therese Alexander, who tracked down and processed reference information along with her other duties at Harry Markowitz Company; GanLin Xu, who read this entire volume and made invaluable observations and suggestions; and Barbara Markowitz for her unfailing interest and encouragement.
Harry M. Markowitz
San Diego, CA
March 2016
6
THE PORTFOLIO SELECTION CONTEXT
INTRODUCTION
The four volumes of this book are concerned with the theory and practice of rational investing and, in particular, how risk-return analysis can help human decision makers (HDMs) approximate such investing. As in Volume I of this book, and in Markowitz (1959), we postulate rational decision makers (RDMs) who are like HDMs in their institutions, motivations, and limited information, but who differ from HDMs in having faultless logic, unlimited instantaneous computing capacity and, as we saw in Chapter 1, the ability to accurately perceive their own preferences.
We view the RDM as a platonic ideal that we seek to emulate. The basic assumption of such an approach is that if we do it right, such emulation will improve our own human investment process. Obviously, doing it right
does not mean attempting calculations that are assumed to be trivial for the RDM but are impractical for the HDM. It means, rather, finding economical methods by which the HDM can approximate the actions—and results—of the RDM. Hence the focus throughout much of Volume I was on risk-return approximations to expected utility, after having established in Chapter 1 the role of expected utility maximization in RDM choice.
Volume I was concerned with single-period decision making with known odds, and especially with how to choose between alternative portfolio return distributions. The present volume places such decisions into their context. This context has two major aspects: One aspect has to do with time and the other aspect has to do with the overall opportunities, constraints, and goals of the investor. We will view the choice of portfolio today
as a move
in a many-period game. The proper choice of move depends in part on how today’s returns are related to opportunities that might be available tomorrow.
It also depends on the other aspect of context, namely the investor’s degrees of freedom and objectives for its game-as-a-whole.
The Mossin (1968) and Samuelson (1969) game, presented in Chapter 9, considers an investor who starts with initial wealth W0, reinvests it without further deposits or withdrawals until some predetermined end time, and whose utility depends only on his or her final wealth WT. Even with these very restrictive assumptions, the investor’s actions now are highly dependent on the Pratt (1964) and Arrow (1965) risk aversion characteristics of the utility function U(WT). A seemingly minor change in the form of U( ) may lead to major changes in the implied optimal investment behavior.
When we move from highly stylized to real-world investors, additional opportunities, constraints, and objectives must be taken into account, either formally by our analyses or intuitively by the investor. For example, perhaps the investor
is a couple investing both for their retirement and for other major expenditures such as a larger house or their children’s college. How should their choice of portfolio today, including the location of assets in accounts with varying liquidity and tax treatments, be made in light of their multiple objectives? Alternatively, the portfolio to be selected could support a corporation’s DB (defined benefit) pension plan. In that case the investor
is the corporation that supplies these benefits. This raises questions such as: Is it sufficient to seek to stabilize the value of assets minus liabilities as proposed by Sharpe and Tint (1990)? Or need one take into account the correlation between these funding needs and the profitability of the corporation’s principal business? If so, should these be taken into account formally in our models or intuitively by the model user?
TEMPORAL STRUCTURE AND TODAY’S CHOICE
A simple example will illustrate how the joint distribution of
return this period
and
opportunities in later periods
affect portfolio choice today. Consider a game with three points in time—labeled 0, 1, and 2—that are the start and/or end points of two intervals (or periods) labeled 1 and 2, as follows:
Beginning with wealth W0 at time zero, the investor chooses a probability distribution of return, R1, for period 1. After R1 is generated, the investor reinvests (with no transaction costs) his or her wealth, now equal to
W1 = W0(1 + R1)
and receives return R2, ending with wealth
W2 = W0(1 + R1)(1 + R2)
The investor seeks a mean-variance efficient distribution of W2 that approximately maximizes the expected value of a concave utility function U(W2).
Two portfolios are available at time point 0. The investor must choose one or the other and cannot split its funds between them. The values of the two portfolios at time point 1 (at the end of time interval 1) depend on the outcome (A or B) of some event, as follows:
where a and b are dollar amounts and b ≠ 0. At time point 1 only one portfolio will be available. This will have a sure return of
(a + b) if A occurred during the first time interval and
(a − b) if B occurred
Thus if Portfolio One is chosen at time point 0, there is a 50-50 chance that final wealth will equal
whereas if Portfolio Two is chosen, final wealth will, for sure, be
W2 = (a + b)(a − b)
= a² − b²
Portfolio One has the higher expected value of W2, since
On the other hand, if Portfolio Two is chosen, W2 has zero variance. The choice between the two portfolios at time point 0 depends on the investor’s tradeoff between risk and return on W2, which, in turn, depends on the investor’s utility function, U(W2).
The preceding is a hypothetical example of how the returns this year for different portfolios may be related differently to the investment opportunities in the following year (or years). The balance of this section notes two such situations that arose in practice.
Chapter 11 includes sections on the Markowitz and van Dijk (2003) (MvD) heuristic for approximately maximizing the expected utility of an investment-consumption game with a changing forecasted return distribution. This arose out of a situation in which Markowitz (who has an optimization specialty) consulted for Erik van Dijk, who has a forecasting specialty. A hypothetical example reported in Markowitz and van Dijk (2003) and recounted in Chapter 11 contains two assets, a stock
and cash, and includes a stock forecasting model that can be in five states: from very pessimistic to very optimistic. The mean and variance of the stock depend on the predictive state of the forecasting model. The model includes transition probabilities from one predictive state to each of the other predictive states, and transaction costs for changing one’s portfolio. The discussion in Chapter 11 also reports the Kritzman, Myrgren, and Page (2009) application of the MvD algorithm, in fact, to the rebalancing of portfolios managed by State Street Bank, and others.
The number of possible system states is small enough in the MvD experiments, and in some reported in Kritzman et al., to compute the optimum move in every possible state. MvD and Kritzman et al. compare expected utility for the game-as-a-whole of (1) the optimum solution, (2) the MvD heuristic,