The Markowitz hypothesis and the Friedman-Savage hypothesis both address decision-making under uncertainty, specifically in the context of investment and portfolio theory. While the Friedman-Savage hypothesis laid the groundwork for understanding individual preferences under uncertainty, the Markowitz hypothesis represents a significant improvement by introducing the concept of portfolio diversification and risk-return trade-offs. Let's delve into each hypothesis and explore how Markowitz built upon Friedman-Savage's ideas.
Friedman-Savage Hypothesis:
1. Expected Utility Theory:
The Friedman-Savage hypothesis, developed by economists Milton Friedman and Leonard Savage, is based on the Expected Utility Theory (EUT). According to EUT, individuals make decisions by maximizing expected utility, which is a measure of satisfaction or well-being. This utility is derived from the outcomes of different choices and is influenced by the individual's preferences and attitude towards risk.
2. Certainty Equivalent and Risk Aversion:
One key concept in the Friedman-Savage hypothesis is the "certainty equivalent." The certainty equivalent is the guaranteed amount that an individual would find equally satisfying as a risky prospect. The degree of risk aversion is determined by how much less than the expected value of the risky prospect the individual is willing to accept as a certain amount.
3. Indifference Curves:
Friedman and Savage introduced the concept of indifference curves, which represent combinations of wealth and certainty equivalents that provide the same level of satisfaction for an individual. These curves help illustrate the trade-off between risk and return and the individual's preference for a certain level of satisfaction.
4. Risk Premium:
The risk premium, the amount by which the expected value of a risky prospect exceeds its certainty equivalent, reflects the compensation required by individuals for taking on risk. The greater the risk aversion, the higher the risk premium.
5. Limitations of Friedman-Savage Hypothesis:
While the Friedman-Savage hypothesis provided valuable insights into individual decision-making under uncertainty, it had some limitations. Notably, it did not consider the diversification of risk through portfolio construction, focusing primarily on individual assets.
Markowitz Hypothesis:
1. Modern Portfolio Theory (MPT):
Harry Markowitz significantly advanced the field with his development of Modern Portfolio Theory (MPT) in the 1950s. MPT revolutionized investment analysis by introducing the idea that the risk and return of a portfolio depend not only on the individual assets' characteristics but also on their interactions within the portfolio.
2. Efficient Frontier and Diversification:
Markowitz introduced the concept of the efficient frontier, which represents the set of portfolios that offer the maximum expected return for a given level of risk or the minimum risk for a given level of return. The key insight is that by diversifying a portfolio with uncorrelated or negatively correlated assets, an investor can achieve a higher level of return for the same level of risk, or vice versa.
3. Correlation and Covariance:
Markowitz emphasized the importance of considering not only the individual risks and returns of assets but also their correlation and covariance. By combining assets with low or negative correlation, investors can reduce the overall risk of the portfolio without sacrificing return.
4. Risk-Return Trade-Off:
Markowitz's contribution lies in his emphasis on the risk-return trade-off at the portfolio level. While individual assets may exhibit certain levels of risk and return, the combination of assets in a portfolio allows investors to optimize their risk-return profile by balancing different assets' characteristics.
5. Capital Market Line and Security Market Line:
Markowitz introduced the Capital Market Line (CML) and the Security Market Line (SML), which illustrate the relationship between risk and return for an entire market and for individual securities, respectively. These lines help investors understand the expected return for a given level of risk and vice versa.
6. Systematic and Unsystematic Risk:
Markowitz distinguished between systematic risk, which cannot be diversified away, and unsystematic risk, which can be eliminated through diversification. This differentiation laid the groundwork for the development of the Capital Asset Pricing Model (CAPM) and the understanding of how investors are compensated for bearing systematic risk.
7. Sharpe Ratio and Portfolio Optimization:
Markowitz's work also introduced metrics such as the Sharpe ratio, which measures the risk-adjusted return of a portfolio. Investors can use these metrics to evaluate and compare different portfolios, aiding in the selection of optimal portfolios that offer the best risk-adjusted returns.
Comparison and Improvement:
- Portfolio Perspective: The key improvement of the Markowitz hypothesis over the Friedman-Savage hypothesis is the shift from an individual asset perspective to a portfolio perspective. Markowitz recognized the benefits of diversification and demonstrated how combining assets with different risk-return profiles can enhance an investor's overall portfolio.
- Consideration of Correlation: While Friedman-Savage focused on individual preferences and risk aversion, Markowitz introduced the crucial consideration of correlation between assets. The negative correlation or low correlation between assets in a portfolio is a powerful tool for risk reduction.
- Holistic Risk-Return Trade-Off: Markowitz's framework provides a more holistic approach to the risk-return trade-off by considering the entire portfolio. This allows investors to make strategic decisions about combining assets to achieve optimal risk-adjusted returns, rather than focusing solely on individual assets.
- Integration with Capital Market Theory: Markowitz's work laid the foundation for the integration of Modern Portfolio Theory with Capital Market Theory, leading to the development of models like the Capital Asset Pricing Model (CAPM). These models provide insights into the relationship between risk and return at both the individual asset and portfolio levels.
- Practical Applications: The Markowitz hypothesis has found extensive practical applications in investment management, guiding investors and fund managers in constructing diversified portfolios that align with their risk tolerance and return objectives.
In conclusion, the Markowitz hypothesis represents a significant improvement over the Friedman-Savage hypothesis by shifting the focus from individual assets to portfolios and introducing the concept of diversification. Markowitz's insights have had a profound impact on investment theory and practice, providing a framework for investors to optimize their portfolios based on the trade-off between risk and return. The transition from individual asset analysis to portfolio optimization is a crucial step in understanding and navigating the complexities of financial markets.
Subscribe on YouTube - NotesWorld
For PDF copy of Solved Assignment
Any University Assignment Solution
.webp)
