DEFINITION of Homogeneous Expectations
Homogeneous expectations is an assumption in Harry Markowitz's Modern 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. The homogeneous expectations assumption works on the theory that investors are rational actors 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.
BREAKING DOWN 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
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.