What Is Homogeneous Expectations?
Let me explain what 'homogeneous expectations' means in the context of investing. It's an assumption from Harry Markowitz's Modern Portfolio Theory (MPT) that all investors hold the same expectations and would make the exact same choices in any given situation.
Key Takeaways
In MPT, homogeneous expectations mean that every investor expects the same outcomes and selects identically in a scenario. This assumes investors act rationally, influenced only by the facts, not by biases. However, critics point out that people aren't always rational, with varying perceptions and goals affecting their decisions.
Understanding Homogeneous Expectations
You should know that MPT, introduced by Harry Markowitz in his 1952 paper 'Portfolio Selection,' earned a Nobel Prize. It's designed to maximize returns with the least risk, assuming investors avoid risk and that higher rewards come with inherent risks.
Markowitz's idea is to build a portfolio of multiple assets. Even high-risk ones like small-cap stocks can balance out when mixed with others, as different asset classes behave differently in market cycles.
The theory outlines four steps for portfolio construction: security valuation, where you describe assets by expected returns and risks; asset allocation, distributing classes within the portfolio; portfolio optimization, balancing risk and return; and performance measurement, classifying each asset's performance by market and industry factors.
At its core, homogeneous expectations assume all investors share the same inputs for efficient portfolios, like returns, variances, and covariances. If you show investors plans with different returns at the same risk, they'll pick the highest return. Or, for same returns but different risks, they'll choose the lowest risk.
This relies on investors being rational, thinking alike, and sticking to facts— a foundation of many classical economic theories.
Advantages of Homogeneous Expectations
Markowitz's MPT and its homogeneous expectations have transformed how we approach investing, stressing portfolios, risk, security relationships, and diversification.
Many investors skip market timing and opt for buy-and-hold strategies. The balanced allocation MPT promotes has guided them in creating strong portfolios.
Criticism of Homogeneous Expectations
MPT draws criticism because assumptions like these are risky, and homogeneous expectations involve many.
It claims markets are always efficient and investors think uniformly. Behavioral finance studies challenge this, showing people and investors aren't always rational, with diverse perceptions and goals influencing thoughts.
MPT treats all investors the same: they maximize returns without extra risk, understand expectations, ignore commissions, and access identical information. History proves this isn't always true, casting doubt on MPT and homogeneous expectations.
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