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Jun 12, 2014

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The Theory And Practice Of Rational Investing

Book 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 mean–variance analysis.” This is a serious matter. Mean–variance analysis has been the cornerstone of portfolio construction since Markowitz’s 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 mean–variance 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, “Let’s not re-implement Harry Markowitz’s PhD thesis for the millionth time. We can do better.” But we have not. What are the objections to mean–variance analysis, and are they well grounded? Markowitz has devoted Risk–Return Analysis to these questions, concluding that mean–variance analysis is central to finance for good reason. This book proceeds in unhurried steps from a set of incontrovertible premises to the conclusion that mean–variance analysis is the best tool available for addressing a wide range of portfolio-construc tion problems. None of the material in Risk–Return 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 Risk–Return 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 Markowitz’s 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 Risk–Return 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 mean–variance analysis is the key to maximizing expected utility. Know more book reviews here: http://dymanblog.c om/  (Jun 12, 2014 | post #1)