Risk-Return Analysis: The Theory And Practice Of Rational InvestingBook Reviews

Dyman Associates Publishing Inc

The Theory and Practice of Rational Investing, Harry M. Markowitz worries about a great
confusion that reigns in finance namely, the confusion between necessary and
sufficient conditions for the use of meanvariance analysis. This is a serious matter.
Meanvariance analysis has been the cornerstone of portfolio construction since Markowitzs
seminal 1952 article.

Meanwhile, academics and practitioners have been in constant search of the next holy grail that
will guide the allocation of capital. Consider the endless stream of articles proposing
enhancements to meanvariance analysis or substitutes for it. Substantial bodies of literature
discuss optimizers that incorporate higher moments or attempt to replace variance with
alternative risk measures. Another takes account of investors so-called irrational tendencies. I
recall a former colleague saying, Lets not re-implement Harry Markowitzs PhD thesis
for the millionth time. We can do better. But we have not.

What are the objections to meanvariance analysis, and are they well grounded? Markowitz has
devoted RiskReturn Analysis to these questions, concluding that meanvariance analysis is
central to finance for good reason. This book proceeds in unhurried steps from a set of
incontrovertible premises to the conclusion that meanvariance analysis is the best tool
available for addressing a wide range of portfolio-construction problems.

None of the material in RiskReturn Analysis is brand new; much of it has been around for
more than half a century. The packaging, however, is vintage 2014. Proceeding against an
earlier inclination, Markowitz begins RiskReturn Analysis with an axiomatic treatment of
expected utility theory that is similar to what he wrote in his 1959 book on portfolio selection.
He explains that the material was at the back rather than the front of Markowitz (1959)
because [I] feared that no practitioner would read a book that began with an
axiomatic treatment of the theory of rational decision making under uncertainty.
But now, clearly, these matters have become urgent.

Markowitz is betting that now, financial practitioners will pause to consider the theoretical
foundation of the quantitative tools they use routinely. I hope he is right. Every financial
practitioner, every scholar in a quantitative field, and everyone attempting to explain a scientific
theory stands to benefit from Markowitzs lucid exposition.

The hero of the book is a rational decision maker (RDM). A gender-neutral incarnation of the
rational man introduced in Chapter 10 of his 1959 book, the RDM makes no mistakes in
arithmetic or logic in attempting to achieve his clearly defined objectives. Markowitz
argues in Chapter 1 of RiskReturn Analysis that an RDM will seek to maximize expected utility
of return. Further, it is the tendencies of the RDM, and not the tendencies of the human
decision maker, that are relevant to the formulation of investment goals. After establishing
maximization of expected utility as the foundation of portfolio construction, Markowitz argues
that meanvariance analysis is the key to maximizing expected utility.

The remainder of the book is an elegant interplay of theory, empiricism, and practicality. In
Chapter 2, Markowitz draws on several sources, including a 1979 article he wrote with Haim
Levy, to conclude that under broad conditions, a meanvariance optimal portfolio approximately
maximizes expected utility. Moreover, meanvariance optimization is more practical than utility
maximization. Taken from an article Markowitz authored in 2012, Chapter 3 considers a long-
horizon investor who is naturally concerned with geometric return rather than arithmetic return.
Using a centurys worth of data, Markowitz considers six meanvariance approximations to the
geometric mean for a diverse collection of portfolios and macroeconomic indicators. Three of
the six turn out to be useful.

In Chapter 4, Markowitz again uses a centurys worth of data to approximate log utility with
functions of such alternative risk measures as value at risk, conditional value at risk, and
semideviation. Markowitz finds that approximations based on variance alternatives do not
improve on approximations based on variance. The chapter concludes with an acknowledgment
that the study is not comprehensive and challenges proponents of alternative risk measures:

Conceivably, other functions [of the alternatives] would perform better than those
tried here. If such is to be shown, proponents of alternative risk measures need to
get beyond their current line of argument, which goes roughly as follows:
Distributions are not normal; therefore, meanvariance is inapplicable; therefore,
my risk measure is best.

The final chapter, which relies on prior research by Markowitz and several others, considers the
question of how an investor should choose a portfolio from the meanvariance efficient frontier.
The essential parameter is risk aversion, and Markowitz proposes to gauge an investors risk
aversion by using estimates of return distributions for actual portfolios.

If meanvariance analysis is truly sound, what explains the effort dedicated to pre-empting it?
Markowitz suggests that neglect may play a role: Quiggin (1998, p. 8) says, The
Expected Utility approach initially faced strong competition from meanvariance
analysis, exemplified by the work of Markowitz (1959) on portfolio analysis, but the
logical foundations of this approach were far more dubious than those of expected
utility theory. An examination of the Table of Contents of Markowitz (1959) would
have shown that the premises of utility analysis and the premises that Markowitz
(1959) proposed in support of meanvariance analysis are identical.

But then, it is easy to identify with John Quiggin: In a 2003 article, M.V. Simkin and V.P.
Roychowdhury estimated that only 20% of citers have read the article or book they cite. This
finding highlights a dilemma: How can a researcher master an overwhelming body of literature
when time is so limited?

In the preface to RiskReturn Analysis, Markowitz explains that the current volume is the first of
a four-volume series, and he outlines the material for the subsequent volumes. Future topics
include von Neumann and Morgensterns game theory; the Bellman equation and dynamic
programing; decision making under uncertainty as developed by Descartes, Hume, and Savage;
the role of Bayesian statistics in portfolio construction; data mining; and the question of
whether portfolio analysis can take advantage of advancing technology.

The preface concludes with this:

This is clearly an ambitious program, especially considering that the undersigned is
in his mid-eighties. Following this preface and acknowledgments is an outline of
plans for Parts II, III, and IV. The aim is to provide enough information so that a
diligent scholar could more or less reproduce these parts as now planned in the
event that the undersigned is unable to do so.

So, the current volume is really just a beginning. RiskReturn Analysis is a wonderful work in
progress by a remarkable scholar who always has time to read what matters, who has the
deepest appreciation of scientific achievement, and who has the highest aspirations for the
future.

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