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Safty First!

Our survey of portfolio theories continues; we have already evaluated Modern Portfolio Theory, the Capital Asset Pricing Model and the Arbitrage Pricing Theory in earlier blogs, and now turn to a series of articles on Behavioral Portfolio Theory (BPT).  Recall that as we continue to lay out a financial framework, our ultimate goal is to figure out whether hedge funds actually provide alpha returns to investors.

Whereas both CAPM and ABT assume that investors are proceeding from a single unified motivation – to maximize the values of their portfolios – BPT instead suggests that investors have a variety of motivations and structure their investments accordingly.  Think of a layered pyramid, in which the base is set up to protect against losses and the top designed for high reward.  This has been characterized as the “government bond and lottery ticket” portfolio because of the extreme divergence of goals.

One of the earliest attempts at BPT was Safety-First Portfolio Theory (SFPT, Roy 1952). The theory posits that investors want to minimize the probability of ruin, which is defined as when an investor’s wealth W falls below his subsistence level s:

min Pr(W < s).

SFPT, like the other portfolio theories, makes a few assumptions:

  • a portfolio has a return mean μP and return standard deviation σP;
  • the risk-free asset RF is not available;
  • investors trade off assets according to the expected utility of the assets and the law of diminishing returns;
  • the subsistence level s is low; and
  • the distribution of portfolio returns is normal (bell-shaped).

In short, an investor wants to own a portfolio for which

(s – μP) / σP

is minimized.

Later refinements of the theory included:

  • relaxing the fixed value s;
  • constraining the probability of ruin such that it never exceeds a predetermined ruin probability
  • expecting investors to maximize wealth within the safety-first constraint

As an early behavioral portfolio theory, SFPT has a somewhat simplified vision of investor as primarily risk-adverse. Also, it postulates that investors follow utility theory in their decision-making, an assumption widely discredited by empirical studies.

We progress next time to a theory that had its roots in SFPT: SP/A Theory, which deals with security, potential, and aspiration. Don’t miss it!

Our risk/return series continues with a review of Modern Portfolio Theory (MPT). We’ve already looked at alpha, beta, efficient markets, and returns.  Our ultimate goal is to evaluate the role of alpha in hedge fund profitability, how to replicate hedge fund results without needing alpha, and finally how you can start your own cutting-edge hedge fund using beta-only replication techniques.

MPT suggests that a portfolio can be optimized in terms of risk and return by carefully mixing individual investments that have widely differing betas. Recall that beta is return due to correlation with an overall market (known as systematic risk). To take a trivial example, if you hold equal long and short positions in the S&P 500 index, your portfolio would have an overall beta of (.5 * 1 + .5 * -1) = 0.  There would be no risk, but in this case, there would be no return either, except for the slow drain of commissions, fees, etc.

Continue reading “Modern Portfolio Theory – Part One” »