What Is Homogeneous Expectations?
- Homogeneous expectations is an assumption in modern portfolio theory that all investors expect the same and make identical choices in a given situation.
- It posits that investors are rational actors and are not influenced by anything but the facts of the matter at hand.
- Critics have questioned that premise, arguing that people and investors are not always rational and have different perceptions and goals that impact their thought processes.
Understanding Homogeneous Expectations
MPT, pioneered by Harry Markowitz in his 1952 paper "Portfolio Selection," is a Nobel prize award winning theory. It is an investment model designed to maximize returns while taking the lowest possible risk—MPT assumes that all investors are risk averse and that risk is an inherent part of higher reward.
Markowitz argued that the solution is constructing a portfolio of multiple assets. When assets considered to be high-risk, such as small-cap stocks, are placed alongside others, their risk profile changes, balancing everything out because each asset class acts differently during a market cycle.
According to the theory, there are four steps involved in the construction of a portfolio:
- Security valuation: Describing various assets in terms of expected returns and risks
- Asset allocation: Distributing various asset classes within the portfolio
- Portfolio optimization: Reconciling risk and return in the portfolio
- Performance measurement: Dividing each asset's performance into market-related and industry-related classifications.
Homogeneous expectations is a core principle of MPT. It basically assumes all investors have the same expectations regarding inputs used to develop efficient portfolios, including asset returns, variances, and covariances.
Example of Homogeneous Expectations
According to homogeneous expectations, if investors are shown several investment plans with different returns at a particular risk, they will choose the plan that boasts the highest return. Alternatively, if investors are shown plans that have different risks but the same returns, they will choose the plan that has the lowest risk.
As you can see here, the homogeneous expectations assumption works on the theory that investors are rational actors. They all think alike and are not influenced by anything but the facts of the matter at hand. This is also an underlying assumption of many classical economic theories.
Advantages of Homogeneous Expectations
Markowitz’s MPT and homogeneous expectations theory has revolutionized investing strategies, emphasizing the importance of investment portfolios, risk, and the relationships between securities and diversification.
Many investors avoid attempting to time the market, preferring instead to buy securities and then hold onto them over the long-term, known as the buy and hold strategy. The balanced asset allocation approach, championed for Markowitz, has helped guide them to build robust portfolios.
Criticism of Homogeneous Expectations
MPT has also attracted plenty of backlash. Making assumptions is always dangerous and homogeneous expectations makes plenty of them.
The theory posits that markets are always efficient and that investors all think alike. Studies in behavioral finance have questioned that premise, arguing that people and investors are not always rational and have different perceptions and goals that impact their thought processes.
MPT categorizes investors as the same, suggesting that all of them want to maximize returns without taking on unnecessary risk, understand expected returns, do not factor in commissions when making decisions, and have access to the same information. History has shown that this is not always the case, questioning the validity of MPT and its core tenet: the notion of homogeneous expectations.