Further to Asset Price Trend Theory: Decision Making, Optimization, Fears and Aspirations, and Notions of Market Efficiency

Abstract

In finance, decision making and choice requires that we assume that asset prices tend to trend. This assumption also logically enables us to construct exits to limit losses and protect capital. But investors have good reason to be uneasy regarding the potential for significant loss when using a traditional Markowitz framework to guide investment decisions. This is because Markowitz-optimized portfolios assume that assets are fully and continuously invested. Accordingly, for given levels of expected return, they can aspire to reduce variability of returns – typically pursued through asset class diversification, but not to strictly limit losses. ‘52/’59 Markowitz and subsequent extensions thus confine the scope of risk management to pursuit of risk moderation – the possibility of significant loss is persistent and inescapable.Herein we show how the constraint that assets be fully and continuously invested is inconsistent with basic decision theory, as it disallows a natural extension of the assumption that asset prices tend to trend – the use of exits to limit losses. A simple progression of logic illustrates how decision making and choice requires the assumption that asset prices tend to trend systematically. Extending this logic then naturally leads to a conceptual framework enabling pursuit of risk containment (limiting variability of returns), in addition to risk moderation (reducing variability of returns). Note that investors routinely fail to properly distinguish between risk moderation and risk containment – arguably one of the most important distinctions to be made in finance. We herein explore implications for the traditional ‘52’59 Markowitz approach to portfolio theory when the assumption that asset prices tend to trend is fully reflected in related models. And we provide a new perspective for review of studies relating to the efficient market and random walk hypotheses which sometimes employ elements of the structurally incomplete Markowitz model. Relative to “Asset Price Trend Theory: Reframing portfolio theory from the ground up” (Dubois [2013]), this paper also revisits and broadens aspects of asset price trend theory’s (APTT) decision-making premise, provides suggestions regarding a general approach to optimization within the APTT conceptual framework, and dissects key investor fears and aspirations in the context of the traditional Markowitz framework and the APTT framework.