Portfolio Selection

Abstract

THE PROCESS OF SELECTING a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performances and ends with the choice of portfolio. This paper is concerned with the second stage. We first consider the rule that the investor does (or should) maximize discounted expected, or anticipated, returns. This rule is re- jected both as a hypothesis to explain, and as a maximum to guide in- vestment behavior. We next consider the rule that the investor does (or should) consider expected return a desirable thing and variance of re- turn an undesirable thing. This rule has many sound points, both as a maxim for, and hypothesis about, investment behavior. We illustrate geometrically relations between beliefs and choice of portfolio accord- ing to the "expected returns-variance of returns" rule. One type of rule concerning choice of portfolio is that the investor does (or should) maximize the discounted (or capitalized) value of future returns.1 Since the future is not known with certainty, it must be "expected" or "anticipated" returns which we discount. Variations of this type of rule can be suggested. Following Hicks, we could let "anticipated" returns include an allowance for risk.2 Or, we could let the rate at which we capitalize the returns from particular securitie