The Portfolio Theorists: Von Neumann, Savage, Arrow and Markowitz

230 Pages·2012·0.66 MB·English

by  Colin Read (auth.)

The Portfolio Theorists
Von Neumann, Savage, Arrow,
and Markowitz
Colin Read
The Portfolio Theorists
Great Minds in Finance
Series editor: Professor Colin Read
Titles include:
The Life Cyclists
The Portfolio Theorists
The Rise of the Quants
The Effi ciency Hypothesists
Great Minds in Finance
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The Portfolio Theorists
Von Neumann, Savage, Arrow,
and Markowitz
Colin Read
© Colin Read 2012
Softcover reprint of the hardcover 1st edition 2012% 978-0-230-27414-3
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ISBN 978-1-349-32431-6 ISBN 978-0-230-36230-7 (eBook)
DOI 10.1057/9780230362307
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Contents
List of Figures and Tables vii
Preface to the Great Minds in Finance series viii
1. Introduction 1
2. A Roadmap to Resolve the Big Question 6
Section 1 John von Neumann 9
3. The Early Years of John von Neumann and
Oskar Morgenstern 11
4. The Times and the Beginning of an Era 19
5. The Theory of von Neumann and Morgenstern 32
6. Applications and Elaborations of the von
Neumann- Morgenstern Model 46
7. The Later Life and Legacy of von Neumann and
Morgenstern 56
Section 2 Leonard Jimmie Savage 71
8. The Early Years 73
9. Friedman and Savage’s Times 80
10. The Theory of Friedman and Savage 91
11. Applications of the Concept of Subjective Probabilities 106
12. Life and Legacy 114
Section 3 Kenneth J. Arrow 125
13. The Early Years 127
14. The Times 140
15. Arrow’s Great Idea 148
16. Applications of the Contingent Claims Model 159
17. Life, Legacy, and the Nobel Prize 165
Section 4 Harry Markowitz 171
18. The Early Years 173
19. The Times and a New Paradigm in Personal Finance 177
v
vi Contents
20. The Theory of an Efficient Portfolio 184
21. Applications of Portfolio Theory 193
22. Life, Legacy, and the Nobel Prize 200
Section 5 What We Have Learned 205
23. Combined Contributions in Portfolio Theory 207
24. Conclusions 211
Glossary 214
Notes 218
Index 226
List of Figures and Tables
Figures
4.1 Utility increasing at a diminishing rate 29
10.1 The risk premium for risk- averse individuals 95
10.2 The risk premium for risk- loving individuals 96
11.1 The Markowitz criticism 110
11.2 The Markowitz solution 111
12.1 Probability of doubling money at the roulette wheel 119
15.1 Equilibrium with a separating hyperplane 150
20.1 The Markowitz bullet 189
20.2 The Markowitz bullet and the capital allocation line 189
20.3 Various choices of risk and return along the capital
allocation line 191
Table
13.1 Bank failures 1921–1933 131
vii
Preface to the Great Minds
in Finance series
This series covers the gamut of the study of finance – from the s ignificance
of financial decisions over time and through the cycle of one’s life to the
ways in which investors balance reward and risk; from how the price of a
security is determined to whether these prices properly reflect all availa-
ble information – we will look at the fundamental questions and answers
in finance. We delve into theories that govern personal d ecision- making,
those that dictate the decisions of corporations and other similar entities,
and the public finance of government. This will be done by looking at
the lives and contributions of the key players upon whose shoulders the
discipline rests.
By focusing on the great minds in finance, we draw together the
concepts that have stood the test of time and have proven themselves
to reveal something about the way humans make financial decisions.
These principles, which have flowed from individuals, many of whom
have been awarded the Nobel Memorial Prize in Economics for their
insights (or perhaps shall be awarded some day), allow us to see the
financial forest for the trees.
The insights of these contributors to finance arose because these
great minds were uniquely able to glimpse a familiar problem through
a wider lens. From the greater insights provided by a more expansive
view, they were able to focus upon details that have eluded previous
scholars. Their unique perspectives provided new insights that are the
measure of their genius. The giants who have produced the theories and
concepts that drive financial fundamentals share one important charac-
teristic: they have developed insights that explain how markets can be
used or tailored to create a more efficient economy.
The approach taken is one taught in our finance programs and practiced
by fundamentals analysts. We present theories to enrich and motivate
our financial understanding. This approach is in contrast to the tools of
technicians formulated solely on capitalizing on market inefficiencies
without delving too deeply into the very meaning of efficiency in the first
place. From a strictly aesthetic perspective, one cannot entirely condemn
the tug- of- war of profits sought by the technicians, even if they do little
to enhance – and may even detract from – efficiency. The mathematics
viii
Preface to the Great Minds in Finance series ix
and physics of price movements and the sophistication of computer
algorithms is fascinating in its own right. Indeed, my appreciation for
technical analysis came from my university studies toward a Bachelor of
Science degree in physics, followed immediately by a PhD in economics.
However, as I began to teach economics and finance, I realized that
the analytic tools of physics that so pervaded modern economics have
strayed too far from explaining this important dimension of human
financial d ecision- making. To better understand the interplay between
the scientific method, economics, human behavior, and public policy,
I continued with my studies toward a Master of Accountancy in taxa-
tion, an MBA, and a Juris Doctor of Law.
As I taught the economics of intertemporal choice, the role of money and
financial instruments, and the structure of the banking and financial inter-
mediaries, I recognized that my students had become increasingly fasci-
nated with investment banking and Wall Street. Meanwhile, the developed
world experienced the most significant breakdown of financial markets in
almost eight decades. I realized that this o nce- in- a- lifetime global financial
meltdown arose because we had moved from an economy that produced
things to one in which, by 2006, generated a third of all profits in financial
markets, with little to show but pieces of paper representing wealth that had
value only if some stood ready to purchase them.
I decided to shift my research from academic research in esoteric fields of
economics and finance and toward the contribution to a better understand-
ing of markets by the educated public. I began to write a regular business
column and a book that documented the unraveling of the Great Recession.
The book, entitled Global Financial Meltdown: How We Can Avoid the Next
Economic Crisis, described the events that gave rise to the most significant
economic crisis in our lifetime. I followed that book with The Fear Factor,
which explained the important role of fear as a sometimes c onstructive
and at other times destructive influence in our financial d ecision- making.
I then wrote a book on why many economies at first thrive and then strug-
gle to survive in The Rise and Fall of an Economic Empire. Throughout, I try
to impart to you, the educated reader, the intuition and the understanding
that would, at least, help you to make informed decisions in increasingly
volatile global economies and financial markets.
As I describe the theories that form the foundations of modern finance,
I show how individuals born without great fanfare can come to be regarded
as geniuses within their own lifetime. The lives of each of the individuals
examined in this series became extraordinary, not because they made an
unfathomable leap in our understanding, but rather because they looked
at something in a different way and caused us all thereafter to look at the
problem in this new way. That is the test of genius.