Homogeneous Expectations

AAA

DEFINITION of 'Homogeneous Expectations'

An assumption in Markowitz Portfolio Theory that all investors will have the same expectations and make the same choices given a particular set of circumstances. The assumption of homogeneous expectations states that all investors will have the same expectations regarding inputs used to develop efficient portfolios, including asset returns, variances and covariances. For example, if shown several investment plans with different returns at a particular risk, investors will choose the plan that boasts the highest return. Similarly, if investors are shown plans that have different risks but the same returns, investors will choose the plan that has the lowest risk.

INVESTOPEDIA EXPLAINS 'Homogeneous Expectations'

Harry Max Markowitz is an American economist known for his pioneering work in the theory of financial economics, and the publication of his essay "Portfolio Selection" (1952) and his 1959 book, "Portfolio Selection: Efficient Diversification." He was awarded the John von Neumann Theory Prize in 1989 and the Nobel Price in Economics in 1990.

Modern Portfolio Theory (MPT) was pioneered by Markowitz. The theory states that risk-averse investors can develop portfolios that optimize or maximize expected returns based on the particular level of market risk. According to the theory, there are four steps involved in the construction of a portfolio:

1. Security valuation - Describing various assets in terms of expected returns and risks

2. Asset allocation - Distributing various asset classes within the portfolio

3. Portfolio optimization - Reconciling risk and return in the portfolio

4. Performance measurement - Dividing each asset's performance into market-related and industry-related classifications

Markowitz's work altered the way that people invested, emphasizing the importance of investment portfolios, risk and the relationships between securities and diversification. His work has been fundamental to the development of the capital asset pricing model.

Markowitz also described the "efficient frontier," a set of optimal portfolios that provide the best expected returns for a defined risk level or the lowest risk level for a defined expected return. Portfolios that fall outside the efficient frontier are considered sub-optimal because they either carry too much risk relative to the return or too little return relative to the risk.

RELATED TERMS
  1. Efficient Frontier

    A set of optimal portfolios that offers the highest expected ...
  2. Harry Markowitz

    A Nobel Memorial Prize winning economist who devised the modern ...
  3. Portfolio

    A grouping of financial assets such as stocks, bonds and cash ...
  4. Asset Allocation

    An investment strategy that aims to balance risk and reward by ...
  5. Modern Portfolio Theory - MPT

    A theory on how risk-averse investors can construct portfolios ...
  6. Markowitz Efficient Set

    A set of portfolios with returns that are maximized for a given ...
Related Articles
  1. Bonds & Fixed Income

    Find The Highest Returns With The Sharpe Ratio

    Learn how to follow the efficient frontier to increase your chances of successful investing.
  2. Fundamental Analysis

    The Capital Asset Pricing Model: An Overview

    CAPM helps you determine what return you deserve for putting your money at risk.
  3. Insurance

    The Dangers Of Over-Diversifying Your Portfolio

    If you diversify too much, you might not lose much, but you won't gain much either.
  4. Active Trading

    Modern Portfolio Theory: Why It's Still Hip

    See why investors today still follow this old set of principles that reduce risk and increase returns through diversification.
  5. Economics

    Understanding Perpetuity

    Perpetuity means without end. In finance, a perpetuity is a flow of money that will be received on a regular basis without a specified ending date.
  6. Trading Strategies

    Capitalize On Collars To Enhance Your Trades

    Trade collaring measures current technicals and makes swift adjustments to account for environmental changes.
  7. Technical Indicators

    Strategies To Trade Volatility Effectively With VIX

    VIX offers a bird’s eye view of real-time greed and fear, while providing a snapshot of the market’s expectations for volatility in the next 30 days.
  8. Fundamental Analysis

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in Modern portfolio theory to quantify investment risk.
  9. Credit & Loans

    Understanding Loan-to-Value Ratio

    Loan-to-value ratio (LVR) is a tool used to evaluate the risk in a collateralized loan, usually a mortgage loan.
  10. Fundamental Analysis

    What is a Null Hypothesis?

    In statistics, a null hypothesis is assumed true until proven otherwise.

You May Also Like

Hot Definitions
  1. Income Effect

    In the context of economic theory, the income effect is the change in an individual's or economy's income and how that change ...
  2. Price-To-Sales Ratio - PSR

    A valuation ratio that compares a company’s stock price to its revenues. The price-to-sales ratio is an indicator of the ...
  3. Hurdle Rate

    The minimum rate of return on a project or investment required by a manager or investor. In order to compensate for risk, ...
  4. Market Value

    The price an asset would fetch in the marketplace. Market value is also commonly used to refer to the market capitalization ...
  5. Preference Shares

    Company stock with dividends that are paid to shareholders before common stock dividends are paid out. In the event of a ...
  6. Accrued Interest

    1. A term used to describe an accrual accounting method when interest that is either payable or receivable has been recognized, ...
Trading Center