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

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. Harry Markowitz

    Harry Markowitz is a Nobel Memorial Prize winning economist who ...
  2. Modern Portfolio Theory - MPT

    Modern portfolio theory (MPT) looks at how risk-averse investors ...
  3. Mutual Fund Theorem

    The mutual fund theorem is an investing strategy using mutual ...
  4. Traditional Theory Of Capital Structure

    The Traditional Theory of Capital Structure states that a firm's ...
  5. Accounting Theory

    Accounting theory is the field of assumptions, methodologies ...
  6. Rational Expectations Theory

    The rational expectations theory posits that individuals make ...
Related Articles
  1. Managing Wealth

    Modern Portfolio Theory: Why It's Still Hip

    Investors still follow an old set of principles, known as modern portfolio theory (MPT), that reduce risk and increase returns through diversification.
  2. Managing Wealth

    Manage Investments And Modern Portfolio Theory

    Modern Portfolio Theory suggests a static allocation which could be detrimental in declining markets, making it necessary for continuous risk assessment. Downside risk protection may not be the ...
  3. Investing

    Seven Controversial Investing Theories

    Find out information about seven controversial investing theories that attempt to explain and influence the market as well as the actions of investors.
  4. Investing

    How to Create a Low-Risk, High-Return Portfolio

    Modern portfolio theory states diversification will create a lower-risk, higher-return portfolio.
  5. Financial Advisor

    Example of Applying Modern Portfolio Theory (MPS)

    Modern Portfolio Theory: brush up on key mathematical framework used in investment portfolio construction.
  6. Investing

    Explaining The Efficient Frontier

    Most investment choices involve a tradeoff between risk and reward. The "Efficient Frontier" is a modern portfolio theory tool that shows investors the best possible return they can expect from ...
  7. Investing

    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.
  8. Investing

    The Workings of Equity Portfolio Management

    Portfolio management is a necessity, not an afterthought, in achieving analytical efficiency.
  9. Investing

    Arbitrage Pricing Theory: It's Not Just Fancy Math

    What are the main ideas behind arbitrage pricing theory? Find out how this model estimates the expected returns of a well-diversified portfolio.
RELATED FAQS
  1. What are the differences between weak, strong and semi-strong versions of the Efficient ...

    Discover how the efficient market theory is broken down into three versions, the hallmarks of each and the anomalies that ... Read Answer >>
  2. What's the difference between agency theory and stakeholder theory?

    Learn how agency theory and stakeholder theory are used in business to understand common business communication problems ... Read Answer >>
  3. How is covariance used in portfolio theory?

    Learn how covariance is used to reduce risk in modern portfolio theory, how covariance is calculated and how it is used to ... Read Answer >>
  4. What is the chaos theory?

    The chaos theory is a complicated and disputed mathematical theory that seeks to explain the effect of seemingly insignificant ... Read Answer >>
  5. How does covariance impact portfolio risk and return?

    Understand how covariance is related to the risk and return of a portfolio of stocks, and learn how covariance is used to ... Read Answer >>
Trading Center