Before we start, let us talk about a theory that won Harry Markowitz a Nobel Prize. It is called the Modern Portfolio theory. It says that investors can create a portfolio that can maximize returns by taking a certain risk. In terms of risks, they can reduce them if they use a quantitative method for diversification. In a nutshell, it is an investment model that can help investors have more returns while taking the slightest possible risk. Hence, MPT assumes that all investors want to avoid risks, and these risks are needed to get a better reward. We are talking about this because it plays a significant role in today’s main topic: homogenous expectations. Let us start.

Modern portfolio theory and homogenous expectations

In Harry Markowitz’s Modern Portfolio Theory, there is an assumption saying that investors have similar expectations. If there is a given situation, investors tend to make the same choice. We call this assumption “homogenous expectation.”

Markowitz believes that an investor should place multiple assets when making a portfolio. Different asset classes do not behave the same way in a market cycle. Hence, if a high-risk investment such as small-cap stocks is placed beside other assets with different risks, a balance is created, and their risk profile changes as well. MPT suggests four steps in making a portfolio:

• Security valuation. This step is a description of different assets about their expected returns and risks.
• Asset delegation. It is the distribution of the asset classes in the portfolio.
• Portfolio efficiency. It is a reconciliation of risk and return.
• Performance. A division of every asset’s performance to classifications relative to the market and industry.

Homogenous expectations are like the heart of MPT. This principle assumes that all investors have similar expectations about inputs in developing portfolios. This also includes asset returns, variances, and even co-variances.

Why use homogenous expectations?

The Nobel Prize is not given to just anyone. And if Markowitz and MPT achieved this, it means that it must have been a revolutionary idea. It changed the way people see investing strategies as it stresses the significance of investment portfolios, risks, and the relationship between securities and diversification.

Investors buy and hold securities in the long run instead of timing the market. Having a balanced asset allocation has helped them have a better portfolio.

Doubts on this assumption

A theory will always have critics, even if it already won a Nobel Prize. But why? Assumptions will always be assumptions at the end of the day, and other people find this dangerous. Homogenous expectations state that all investors think the same way. However, some studies say that people can be irrational sometimes. They may believe and aim differently. Others beg to disagree that not everyone thinks the same way, so they say that MPT is not valid, let alone the homogenous expectations.

Let us cite some scenarios as we end today’s topic.

Homogenous expectations say that if several investors choose from a pool of various returns at particular risk, they will all choose the one that can give the most returns. Let us look at another scenario. If several investors have to choose from a pool of plans with different risks but with the same return, they will all choose the one with the lowest risk. We see that investors are rational and think the same way with nothing but facts and no influence