Harry M. Markowitz - Risk-Return Analysis, Volume 3

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[T]he race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favour to men of skill; but time and chance happeneth to them all.

Ecclesiastes 9:11

Excuse me sir, but

How much longer would it take

If we did it right

The first time?

Harry Max Markowitz

Lifes tragedy is that

We get old too soon

And wise too late.

Benjamin Franklin

If not now, when?

If not me, who?

Hillel, the Elder

T his third volume of a four-volume book, Risk-Return Analysis: The Theory and Practice of Rational Investing, begins with on its own so that interested readers could begin the study of its contents.

As explained in the prefatory material of Volume I, the topics of the four volumes parallel the topics of the last four chapters of Markowitz (1959). Specifically, Volume I considers single-period decision analyses assuming known odds as did Markowitz (1959) Chapter 10. Volume II considers many-period analyses, still assuming known odds, as did Markowitz (1959) Chapter 11. The present volume is concerned with rational decision-making in the face of uncertainty, i.e., when odds are not known, as did Markowitz (1959) Chapter 12. The fourth volume will cover application matters not covered, or not adequately covered, in the prior three volumes. The chief difference between was written a priori, when the world had no experience with the practical application of MVA (Mean Variance Analysis), whereas Volume IV of the present book is based on over a half-century of MVA experience.

Each volume of this book distinguishes between the actions of a hypothetical Rational Decision Maker (RDM) and those of a Human Decision Maker (HDM). Our focus is on rationali.e., RDMaction, and HDM approximations to it. The reason that the HDM makes an appearance in these volumes at all, is because (as the subtitle of this book promises) the book deals with practice as well as theory. I do not mean by this the questionable practices documented in behavioral studies such as that of Odean (1999) or McKay (2013, 1841). Rather, I mean existing and proposed HDM practices that seek to emulate the behavior, and approximate the results, of the RDM. Discussions of this sort are scattered throughout the volumes of this book, including, but not only, Chapter 11 in Volume II, on Judgment and Approximation.

The RDM is a fictitious creation. Like other fictitious creationssuch as the unicorn, or the fictional as opposed to the historical St. Nicholaseach storyteller can ascribe to it whatever attributes his or her audience can be persuaded are appropriate for the entity. The RDM of Mossin and Samuelson, discussed in Chapter 9, is a solitary investor. As Chapter 6 (in Volume II) spelled out in some detail, my RDM can be an individual (of either gender of course), a family, or an institution such as a university or symphony orchestra.

As a specific example, the frontice material of Volume II introduced a prototypical RDM as a family with husband, wife, four children, a dog, and a catall rational. But, as Markowitz (1959) emphasized, a rational entity is neither omniscient nor omnipotent. In particular, the rational cat cannot catch the irrational rat. This is perfectly plausible despite the fact that a hungry natural cat can eventually catch some natural rat. Presumably, our rationalbut fussy, of coursecat would prefer to finish the tuna in its bowl than to eat a raw rat. Its moves toward catching the rat are perfunctory. Perhaps the Rational Cat (RC) does not really want to catch the Irrational Rat (IR) because it is a clean and sanitary white ratsaved by RCs good-hearted family from its fate in a research lab. Perhaps playing cat and mouse with IR is RCs only entertainment when the humanoid RDMs are out for the day, and either the RC or the Rational Dog (RD) is tired of playing hide and seek.